Index innovation

Index innovation

tony-raw-2011

FTSE

FTSE’s collaboration with over 20 exchanges, asset class specialists and research houses worldwide enabled the index provider to blend innovative trading strategies with diversified alternative asset classes – placing the index provider at the forefront of index innovation this year.

“This year has been a year of partnerships,” says Tony Raw, managing director at FTSE International in London. “Embedding different trading strategies with distinctive philosophies has been imperative; we have been working with different houses applying our quant, research, and index calculation capabilities and coming up with the best derivation of an index leading to successful issuances structured products and ETFs linked to our indexes.”

Aiming to answer investor’s call for alternative weighted indexes that avoid the 'concentrations and trend following bias' of market-cap weighted indexes, FTSE focused on providing investors with a broad range of non market-cap index solutions, offering investors different approaches to index construction.

These indexes which are often complementary to existing market-cap weighted strategies, resulted in total number of ETFs based on FTSE indexes to skyrocket to 130 ETFs, with a total of $50 billion asset under management (AUM) and $3 trillion benchmarked against them. “What FTSE have been really effective in doing this year, is placing the microscope on controlling risk by asking why invest in companies that give a higher return but entail higher risk?” says a London-based market participant.

“The scope for alternative weighting this year has been huge, and FTSE has been pushed all boundaries in its effort to tap into new trends.” In conjunction with QS Investor, FTSE launched its Diversification Investing (DBI) index series in March 2011, designed to promote diversification across countries and industry sectors.

The index series was launched to better diversify the correlations between industries and between markets by re-weighting countries and industries and avoid concentration risk and momentum effect using a transparent, rules-based formula.

The index provider captured equity market returns with improved risk/reward efficiency by launching its FTSE EDHEC-Risk Efficient Index Series in partnership with EDHEC-Risk Institute in December 2010.

The indexes aimed to achieve the highest possible return-to-risk efficiency by maximising the Sharpe ratio. “The index aims to produce outperformance in the long run, and the critical point of it is diversification,” says Eric Shirbini part of the research team at EDHEC-Risk in London.“You need to diversify across the universe so that you are able capture the opportunities across all stocks – effectively maximising returns and minimising risk.”

FTSE’s StableRisk indexes were created to do just that – effectively constructing a portfolio of liquid futures contracts to represent each asset class, which would then be rebalanced, as often as daily, with the objective of maintaining the portfolio’s volatility at a given level, including periods of high market volatility.

The indexes were launched in collaboration with AlphaSimplex and offered investors exposure to four asset classes: equities, commodities, currencies and interest rate – effectively capturing long-term expected returns with extreme shifts in short-term risk levels, the indexes were expected to exhibit relatively stable risk levels. In furtherance of the risk-controlled theme, FTSE launched the FTSE StableRisk Trend index, following a simple momentum portfolio policy and holding both long and short futures contracts.

Assets with prices that appeared to be trending upward were held long and those with prices that appeared to be trending downward were sold short. “We have continued to broaden the asset classes we use within each index, the weighting method, and diversify the constituents, so that if an ETF provider or a structurer wants to replicate the performance we have every variation covered,” says Raw.

FTSE extended its range of Short and Leveraged indexes, designed to exploit volatilities in the UK market by enabling investors to go short the market or gear up, the indexes formed the basis for a series of structured products launched by a number of banks including RBS, and ETF providers including Lyxor and Deutsche Bank.

Increased demand for exposure to industrial metals and infrastructure has shaped index development trends this year. In an attempt to meeting investor demand, FTSE partnered with DIFC Investments and Merit Commodity Partners to launch the FTSE Physical Industrial Metals index series, providing investors with exposure to aluminium, copper, zinc and nickel by holding physical cash and forward contracts.

“The indexes provided investors with tools to hedge against future supply constraints,” says Raw. “The index is by nature reflective of the value of the cash or spot position or a pre-paid forward contract as established by the index calculation methodology each month and in that way the index is based on the physical markets.”

FTSE also launched a set of nine infrastructure indexes in January 2011, seeking to provide investors with a balanced exposure to global infrastructure and reflects the market’s evolving definition of the asset class. In addition to reducing the risk of over-concentration in individual sectors, the indexes offered investors the flexibility to tailor exposure in accordance with their investment objectives and risk appetites.

The FTSE EPFR EM Fund Flows index launched in November 2010 is another index that illustrates the index provider’s efforts to innovate strategy indexes that not only obtain pure market performance but also give investors a clear indication of the direction of markets. FTSE teamed up with fund flows data provider Emerging Portfolio Fund Research (EPFR) to create a factor-adjusted version of the FTSE Emerging Markets Index; measuring weekly flows into each country and look at the relative strength of the countries.

The index provider has been busy in the Ethical, Social and Governance (ESG) alternative investment space as well. This year, FTSE developed an independent policy committee that has ultimate responsibility for the rules and methodology applied in moving from negative screening towards more positive selection criteria. In May, FTSE launched the FTSE4Good ESG ratings, providing investors with an overall ESG score that breaks down into separate environmental, social and governance scores. For each theme a risk metric places a company into low-, medium- or high-risk categories.

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