Why not all indices are created equal

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Laurence Black, The index Standard

By Philippa Aylmer – While the ETF industry is rightly famed for its high level of innovation, getting the right mix of ETFs in a portfolio has become increasingly complex, with products ranging from plain vanilla equity to high yield emerging market fixed income.

Laurence Black, Founder of The Index Standard, believes that it is really the indices behind the ETF products that drive returns and when thinking about an allocation to ETFs, investors should start first by identifying the most robust and well-designed indices. 

“It used to be that with high fees at 1.5 or 2 per cent, it was a simple case of picking a low fee ETF product. But now with the average fee around 19 basis points, it is the performance of the index itself that should come under scrutiny.” 

According to Black, year-to-date, there is a 32 per cent difference between the best and worst performing factor indices. “This shows that those who identify the right index are more likely to pick the right ETF.”

Black, whose career creating and running global indices spans two decades, nine years of which were spent spearheading Barclays’ index partnerships with Robert Shiller, and Joel Greenblatt and Jim Rogers at other firms, has recently launched an independent ratings system and forecasting service, The Index Standard. 

Black emphasises that rather than assessing the fees and liquidity of an ETF like many other ratings providers, The Index Standard, focuses solely on the indices. 

“We look under the bonnet of the indices. Even if the names of ETF funds sound similar, we find that the index methodologies are often very different. Therefore, I believe the index is the main driver behind returns,” he says, adding that while everyone is advised to read the index methodologies, the reality is that: “even financial advisers and intermediaries will not have time to read a 50-page document filled with technical terms.” 

The process uses over 30 metrics, grouped into categories which Black believes are vital to the understanding of index construction. These include design robustness, transparency, performance, efficiency and capital at risk. Points scored in each of these categories contribute to the overall rating of each index. 

Each index is given a rating, either Platinum or Gold for a high performing index or Neutral or Watch for ones that are average or weak. 

“These are all encompassing metrics that enable investors to gain a clear understanding of how an index operates and to ascertain its key strengths and weaknesses,” adds Black.

Diversification within an index is crucial. “You don’t want too much weight in a single stock, or in the top 10 stocks, or to overweight a sector because it can lead to bad outcomes for investors. I also like to make sure that the mechanism of an index is well-designed and that there are few parameters: not too many bells and whistles. 

“In my experience, it indicates that it might be over engineered or optimised, and investors might not get the returns that they expect. Similarly, just looking at volatility does not tell you the whole picture. You need to look at the value at risk and drawdowns.”

The Index Standard is constantly adding new indices. Currently, the total offering evaluates around 800 of the larger branded well-known indices (MSCI, S&P), of which 400 can be accessed for free. “Right now, we loosely cover anything above a billion and a half on our public website and we also cover the entire fixed index annuity market,” he adds.

In terms of the forecasting tools, it is here that The Index Standard potentially comes into a league of its own. “This is unique in the industry, and combining ratings with forecasting is a powerful combination,” says Black. 

One concern of his is that the process of ETF back testing can result in market timing. “Everyone wants a perfect back test, but this might mean that investors, particularly in the retail market, end up being late to the party.” The Index Standard forecasts can help mitigate some of those risks.

‘The Index Standard index and ETF Forecasts’ evaluate future expected returns in three ways: low, high, and their average, along with historical returns accompanied by some benchmarks, 

“We are able to produce expected returns based on the wisdom of the crowds and on the characteristics those indices have,” states Black.

He explains that they collect long term capital market assumptions from major investment banks and asset management firms across all asset classes and index types and combine these to get aggregate expected returns. 

Then for each index: “We do a comprehensive analysis to understand the characteristics and take those characteristics and run a Monte Carlo simulation 10,000 times. This helps us identify if an index has been overengineered or back test-optimised.” 

The results provide a better sense of which index might offer a higher return, thereby helping investors make smarter decisions on index selection and asset allocation.

Black concedes that there is no crystal ball. However, he says: “Forecasting helps investors distinguish where they should tilt their portfolio; either to sectors, regions or themes that are cheaper or maybe expected to do better in the long term.”

He gives the example of factor investing. “While Momentum has done well, our analysis shows that going forward the next 10 years, it will return around 5 per cent. However, Quality as a factor could return about 8 per cent during the same period.”

The Index Standard officially launched in September 2020 and already has a number of clients using the forecasting tools. “The interest has been astounding and the demand from investors for evaluation of these complex indices is huge,” says Black. 

Their focus is on the US at present but long-term, the goal is to expand to Europe and Asia. 

“There are many more indices and ETFs now, and so much more complex too,” says Black. “I believe our role is to demystify the indices and make investors more knowledgeable. And in a low interest rate world, every extra percentage of return is meaningful.” 


Laurence Black
Founder, The Index Standard

Laurence Black is the founder of The Index Standard and an index advisor to Robert J Shiller, Sterling Professor of Economics at Yale University. Before founding The Index Standard, Laurence was a Managing Director and Head of Quantitative Indices and Strategies at Barclays. During his nine years at Barclays, he oversaw the development of the Barclays index family, with billions invested in the indices. His responsibilities also covered index partnerships, where he worked with clients to deliver customised solutions based on their specific needs. In addition to designing some of the first smart beta/factor indices, Laurence spearheaded Barclays’ index partnerships with Professor Robert Shiller and Nouriel Roubini, as well as Novus Partners.

Before Barclays, Laurence was Head of Indices at ABN AMRO for seven years in London, where he successfully launched indices with well-known investors such as Jim Rogers and Joel Greenblatt. Before ABN AMRO, Laurence worked at Lehman Brothers, Deutsche Bank, and Credit Suisse.

Laurence holds an MBA from the University of Warwick, and a Bachelor’s degree from the University of Cape Town. Laurence resides in New York City with his wife, two children, and a dog. When not thinking about financial matters, he can mostly be found on a tennis court.

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