How systematic and transparent are standard equity indices?
For an index to be entirely systematic and transparent, it is usually required that the index ground rules contain all construction details which are followed by the index so that the process is completely replicable. This is of particular importance if the index is used as an external reference, as for example in the case of a pension fund which approves an index by its board of trustees. If the reference has been created with some layer of transparency, accepting it as a reference may be difficult. However, it cannot be said of all indices that the process used is fully transparent; for example, many standard cap-weighted indices could not possibly be reconstructed from a systematic process and available data. Constitution is in some cases determined by discretionary committee decisions and not simply by applying systematic rules concerning market cap.
Evidence of discretionary committee decisions concerning index constituent selection
To give an illustration of committee decisions, we consider a specific example. On 1st June 2009, Dow Jones Industrial Average (DJIA) replaces General Motors Corp. (GM) and Citigroup Inc. with Cisco Systems Inc. and Travelers Cos. due to the global economic recession. This decision has been criticised subsequently, see e.g. Fuller et al. (2010). Arguments against the change in constituents are that while GM had just filed for bankruptcy protection there was no similar case for Citigroup which had simply issued a declaration that it is “in the midst of a substantial restructuring which will see the government with a large and ongoing stake” (Dow Jones 2009). The need for replacing the existing constituents as well as the choice of replacement has been criticised. While Citigroup has been replaced with a company from the financial sector, the replacement of an industrial manufacturer with an information technology company has been questioned (Fuller et al. 2010). However, the question is not so much whether these replacement decisions were reasonable or not but rather this example shows that such an index is not fully based on systematic and non-discretionary rules.
Sometimes the choice of constituents is dependent on the market situation. Take an example from S&P 500. Arnott et al. (2008) point out that during the period of the tech bubble in 2000, S&P 500 substantially increased the number of companies from Nasdaq, which comprises of technology and emerging growth stocks, in its new additions (24 out of 58 additions come from the Nasdaq). In contrast, during 1995, the Nasdaq only contributed 4 out of 33 additions to the S&P 500. Again, this is an arbitrary decision, no matter if it is right or wrong in the eye of the beholder. After all, this is not something systematic and based on objective criteria that could be defined through an index rulebook.
These are two examples of discretionary committee decisions based on index constituent selection. In practice, the reasons for these decisions may vary from case to case. What is typical of these two cases is that committees often make discretionary decisions on stock inclusion based on considerations of economy or sector representation.
Typically, index providers and exchanges point out the existence of index rules for constituent selection as a proof of transparency. However, sometimes these rules give rather substantial room for discretionary decisions. As an example, the CAC 40 index methodology by Euronext (2006) points out that “The Conseil Scientifique of the CAC40 index may decide to change the composition of the index due to events, which affect one or more of its constituents.” Such a rule obviously implies that the historical constitution could not be reconstructed by simply following systematic rules.
Other discretionary choices
Other than the constituent selection, committees often make discretionary choices with other aspects, including the constituent weights. Recently, many major indices have shifted from total market capitalisation to free-float market capitalisation. The idea behind this is that instead of weighting the companies by their total market capitalisation which investors could not access, it would be more reasonable to weight companies by the shares available to investors. In this way, it could reflect more accurately the market accessible to investors. However, the conversion between the two methodologies involves some discretionary decisions made by the index construction committees. In fact, index providers have different definitions on the free-float conversions. From an investors’ perspective, how exactly to compute the float is not always entirely verifiable.
Another interesting example about the sometimes discretionary decisions made by committees is about the “nationality” of the stocks. Nowadays, it is common to see companies that are incorporated in one country, headquartered in another country, and listed in a third country. This could create discrepancies when index providers assign stocks to countries. While index providers have systematic rules on nationality classification, some index providers also use committees and leave a certain amount of discretionary decision making possibilities for defining the nationality of a company.
In summary, when going into the details, one can ascertain that standard indices which are sometimes understood to be completely transparent and systematic often involve different levels of discretionary choices.
 For examples, some index providers use free float bands rather than an exact free float percentage, and the definition of these bands may vary among providers. For example, FTSE uses the rule that free float less than or equal to 15% will not be eligible for free float greater than 30% but less than or equal to 40% will be using a factor of 40%. MSCI’s “inclusion factor” is equal to its estimated free float rounded-up to the closest 5% for constituents with free float equal to or exceeding 15%. In addition to the different definition of bands, some authors have argued that free float rules are not transparent. Arnott et al. (2008, pp 64) comment on the free-float rules defined by Russell indexes and point out that the company “maintain the enough secret source in the definition of ‘available float’”.
 In Russell, the country assignment has systematic rules for companies with sufficient information available. Otherwise, the stock will be by default assigned to its headquarter country. In FTSE, nationality of stocks is classified based on the categories the stock belongs to. An example of a category would be that “if a company is incorporated in a developed country, and solely listed in another developed country, FTSE will normally allocate the company to the country of listing”. However, in some cases, the committee could override the rule after taking into account factors including tax residency, market perception and currency of trading and etc. In principle, the committee has the right to choose whatever it believes to be appropriate from investors’ perspective,EmailSharePrint