The Cambridge Dictionary defines an index as “a system of numbers used for comparing values of things that change according to each other or a fixed standard.” For the better part of the last century, indexes have been constructed for this very purpose, to allow complex and constantly changing datasets from all areas of human life to be compared and contrasted.
The word index usually calls to mind the financial indexes such as the S&P 500 and the Dow Jones Industrial Average, which track the aggregated performance of specific groupings of equities. However, indexes are used to compare everything from changing consumer prices (Consumer Price Index) to shifting sentiment among purchasing managers (Purchasing Managers’ Index) and on to more unusual data such as the changing length of hemlines in women’s fashion (Hemline Index) or the relative cost of a McDonald’s Big Mac from one country to another (Big Mac Index). Moreover, indexes are used by all kinds of institutions, from governments and businesses to charities and universities.
According to the Index Industry Association’s fourth annual survey, in 2020, the overall number of indexes has increased to a staggering 3.05 million. In finance, the explosion in the number of funds that track underlying benchmarks has been largely attributed to two factors. The first is the emergence of ETFs in the early 1990s. The second is the dominance of passive investing strategies over the past decade or so, particularly since the 2008 crisis. By May 2019, the total assets under management by ETFs reached a record of $5.57 trillion.
Impressive! These statistics show us how deeply indexes have penetrated our lives. But why should a brokerage firm create their own index and where do they begin?
OTC brokerages strive to launch new innovative products for retail clients, which is why creating an index may be a beneficial idea. In the OTC space, where instruments such as foreign exchange and cryptocurrencies are traded in a decentralized manner, there can be hundreds of different venues and data sources. In such an environment, consolidation of the heterogeneous bid/ask price feeds into a reliable reference aggregate price feed can be valuable to brokerages and traders alike, and a customized index may be useful for this purpose.
Another good example may be composite indexes featuring customizable baskets of assets, such as selected U.S. equities. Composite indexes can be constructed and offered as a foundation upon which to construct tradable products. These baskets can include anything from the well-known FAANG stocks, which are popular among newcomers to stock trading, to selections of Bitcoin alternatives in the cryptocurrency space or even collections of assets that follow certain themes, such as gold miners or firms specializing in green technologies. The availability of such indexes and the tradable derivatives give rise to competitive advantages to brokers in an industry where product differentiation is key.
How To Create An Index
Before getting started with index creation, I would advise a brokerage to honestly answer the following questions: Who is the intended consumer of this product? What data exactly is needed and willing to be found by this target audience? And how is your product going to be used by them? One more important point to consider before starting an index creation is data licensing costs. These may quickly get out of hand for real-time dissemination.
Index creation starts with a broad idea: What asset class, segment or market facet should be quantified? Some good calculation agents may suggest their index highlights to kick off this creative process. In other cases, a brokerage firm has to do it by themselves.
When you have a solid investable idea, it should be translated into a well-defined methodological guide for index construction, tackling all crucial features, such as index continuity, desired volatility or rebalancing schedules. Once you have the methodology, you may start constructing a proper backtest and other validation techniques. This will help identify what could be further improved in the index construction. From there, all that's left is to sign off on production, and the index will be available shortly via a variety of APIs, services and file exports.
Of course, there are some risks and challenges a brokerage will face during the process. One of them is how to construct a solid methodology. It should be precise since people tend to stay away from obscurity or vagueness. It should be robust in the long term; otherwise, it will soon become obsolete and no longer represent the original idea. It should also have clear operational descriptions. What market events lead to changes in index constituents and formulas and why?
Obviously, not every brokerage firm has an opportunity to find enough inner resources to support the whole creation process. That's why many of them choose to find an external partner, and this may be challenging enough as well. There are a few qualities that may help to define a good calculation agent:
• Deep knowledge of underlying asset classes used for index construction, including reference data of market instruments involved.
• Transparent transmission of index statuses and essential procedures in the operational life cycle (e.g., opening, closing and settlement values, reweightings and corporate actions).
• Flexibility to accommodate your specific idea or calculation no matter how complex it might be.
• Ease for end-user consumption (APIs, data storages, visual representations and web dashboards).
Even through extremely challenging times, capital markets will play an increasingly vital role as human beings continue to come together and create value in new and unique ways. Indexes are brilliantly simple by design yet at the same time continually offer complex ways to present data services as a wide variety of products designed for all audiences. Through the construction of index solutions that follow the criteria and parameters laid out above, brokerage firms can gain new retail clients and earn loyalty from existing ones.