Index designers must balance two key considerations, representativeness and liquidity, when developing benchmarks for use in investment portfolios, write Xiaowei Kang and Daniel Ung of S&P Dow Jones Indices in the latest issue of the Journal of Indexes Europe.

“In order for an index to be transformed from a passive benchmark into an active investment tool it must be tradeable. The tradeability of an index ultimately relies upon its widespread adoption in the marketplace, and its construction requires the meticulous balancing of often competing factors, which inevitably lead to trade-offs”, note Kang and Ung.

The way in which these competing factors are reconciled differs between asset classes, note the two authors.

“Traditional asset classes, such as equities and fixed income, can usually reconcile well between the requirement for market representativeness and tradeability. In futures-based indices, the trade-offs involve not only representativeness and tradeability, but also the beta exposure to spot and roll costs. Finally, in other alternative asset classes, such as private equity and real estate, obtaining exposure via equity instruments often comes at the cost of higher tracking error and the inability to access manager skills. For this reason, investors should adopt a multi-dimensional perspective when evaluating index tradeability,” say Kang and Ung.

Comment Using: