A Guide to Equity Index Construction


Equity indexes must be constructed by a defined set of transparent rules. This accessible handbook provides clear guidelines and critical insight into the science and methodology of index construction.

Availability: In stock

Equity indexes out-perform the majority of active fund management strategies. Not only will this book teach the reader to construct an optimal index, but it will also assist fund managers to ’know their enemy’.

Index construction is an important scientific process. There are now estimated to be 14 trillion Euros of equities under professional management, and theory suggests that these funds should have an appropriate benchmark in order to match assets and liabilities.

A Guide to Equity Index Construction presents readers with an independent explanation of the processes of methodical index construction. It also addresses the inefficiencies in the construction process that could potentially be exploited by active managers, or those wishing to refine the process, in order to create better indexes in the future.

Documenting best practice and keeping mathematical formulae to a minimum, this guide provides a straightforward set of rules and all the tools and techniques you will need to construct an equity index.

With over 20 years experience in the fund management industry, author Daniel Broby, presents a clear and workable methodology and:

  • equips you with the skills to construct an optimal index;
  • debates the issue of an appropriate benchmark for equity funds;
  • shows the link between the CAPM and index construction;
  • helps you to understand the nature of the underlying return series;
  • makes better fund managers out of active managers through an improved understanding of benchmark construction;
  • enables you to differentiate between the myriad of derivative and synthetic ways to gain exposure to an index.

This powerful reference manual is recommended for fund managers, index constructors, quantitative analysts, risk analysts, CIOs, institutional relationship managers, financial journalists, finance students and academics.

More Information
ISBN 9781904339779
Navision code MGEI
Publication date 2 Apr 2007
Size 155mm x 235mm
Write Your Own Review
You're reviewing:A Guide to Equity Index Construction
Your Rating

Dr. Daniel Broby

As a senior figure in the asset management industry, Daniel Broby is a champion of capital markets. His focus on high level principals, integrity and best practice underlie his professional success.

Daniel built his career on the back of a strong grounding in finance theory. He has an MPhil in economics and an MSc in investment analysis. He was elected an individual member of the London Stock Exchange in 1990; is a Fellow of Chartered Institute of Securities and Investment; a Fellow of CFA UK; and a Visiting Fellow at Durham University. He was presented with the CFA Institute’s Society Leader Award in 2006.

Daniel has had a number of C’ level positions at the largest asset managers in Scandinavia and Russia. These include chief executive officer, chief investment officer and chief portfolio manager. His career, however, has revolved around the London market. He was a board member of CFA UK, and it predecessor, for over 10 years.

Daniel’s focus has always been active asset management. His success in investment performance was recognised by Morningstar who rated the flagship fund he managed for eight years with five stars

Daniel has pioneered a number of investment solutions. He introduced the first regulated hedge fund and pioneered structured products in the Danish market. He has launched various investment funds, including a number focused on frontier markets such as Africa.

Daniel has written two highly recognised books on the profession and numerous articles for industry journals. He was commissioned by the Financial Times to write The Changing Face of European Fund Management.

Daniel has also contributed to the body of financial knowledge by writing A Guide to Equity Index Construction for Risk Books. Securities & Investment Review observed that it “explores in intricate detail the various workings of modern portfolio theory, choosing a benchmark, measuring risk and sampling and selection procedures.“ Professional Investor magazine opinioned that “rarely does a book genuinely represent a first in its field."

Table of contents


1. The Index and Modern Portfolio Theory Introduction

Defining the terms benchmark and index

Defining efficiency


A brief history of equity indexes

Capital asset pricing model

The three-factor model

This book is focused on the practical

The way forward


2. Which benchmark?


Levelling the playing field

Capturing “systematic“ returns

Choosing between arithmetic and geometric approaches

Benchmark methodology: total capitalisation method

Benchmark methodology: price-weighted method

Benchmark methodology: equal weighted method

Should the benchmark adjust for “free float“

The importance of brand

Case Study: choosing a benchmark index for the Norwegian Petroleum Fund’s equity investments


3. Taking risk into account


Volatility and variance as risk proxies


Risk and the efficient frontier

Being careful not to take on too much beta

Avoiding alpha risk

Over-reliance on the index

No garden is without weeds

Risk is a function of the economy

The equity risk premium

Other risk considerations

Case study: What risk premium is normal?


4. The efficiency of the Benchmark index


Efficiency as a moving target

Efficiency and the economy

Pricing efficiency

Operational efficiency

The benchmark as a proxy for the market portfolio

Issues with achieving a pure market proxy

Free float and index efficiency

Roll’s critique of the use of a benchmark

Testing benchmark efficiency

What if fund managers outperform the index?

Tracking error as a measure of efficiency

Active share as a measure of efficiency

The candidate index problem

Case study: The S&P500 - the investor’s choice of benchmark proxy


5. Sampling and selection procedures


Construction methodology

Advanced estimation techniques

The starting point - the base date

The zero-one integer problem

The index divisor

Estimating the key characteristics

Creating rules

Random sampling

Stratified sampling

Apportioning stock weights and the depth of an index

Number of stocks in an index

Size of company in the index

Fixed-share capitalisation indexes

Determining the free float adjustment

Provisional indexes

Which countries to include

Which industries to include

Volume considerations

Fundamental ratios

Short positions

Case study: The MSCI and S&P-IFCI treatment of Korea and Taiwan


6. Establishing statistical method


Descriptive statistics


Cluster analysis

Tables and graphs

Creating a matrix

Simple aggregate unweighted index

Arithmetic Indexes

Geometric Indexes

Which methodology to use - arithmetic or geometric?

Unbiased averages

The Laspeyres index

Paasche index

Fisher index

Marshall-Edgeworth index

Tornqvist index

Carli elementary price index

Dutot elementary price index

Jevons elementary price index

Chain linking


Potential Bias

Case study: The FTSE Mediterranean 100


7. Making the index investable


The key determinants of investability

Trading costs’ impact on investability

Market impact

Bid-ask spread

The impact of futures and options on investability

Rising liquidity

Privatisations and new issues

What size is investable?

Length and timing of trading

Size capitalisation and investability

Free float and investability

Client investability requirements

Case study: Bulgaria - an illiquid emerging market


8. Collection and Processing of Data


Clean data

Data preparation

Data requirements

Static data

Dynamic data

Building the database

Common errors

Public information

Common aggregating services

Direct exchange price feeds

Corporate actions

Coping with data volatility

Issuer name






Survivorship bias

Case study: Establishing a historic data series in France


9. How to Handle Industries


What is an industry?

Standard Industrial Classification

Global Industry Classification Standard

Industry Classification Benchmark

Fama and French Industrial classification

Industrial change

Herfindahl index

Creating a sector-neutral index

Consumer-goods industry - non-cyclical

Consumer goods industry - cyclical


Financial sector


Basic industrial sectors

Basic equipment industry

Telecommunication services

Utility services

Changing industry

Case study: A specialist sub index - the Macquarie Global Infrastructure Index (MGII)


10. How to Handle Factor Exposure


The arbitrage pricing model

Should factors be used in benchmark construction?

Single or multiple factors

Economic factors

Fundamental factors

Country and sector factors

Growth and value factors

Non-linear-style probability

Size factors

Interest rate factors

Country factor exposure

Integration, covariation and correlation

Conditional versus unconditional models

Undertaking factor analysis

The P8 portfolio test

Case study: A style index - S&P500/Citigroup Value Index


11. How to Handle Countries and Currencies


Countries and the CAPM

International CAPM


National history

Home country bias

National industry clustering

Increasing integration

Time zone

Defining developed markets

Defining emerging markets

Multi-currency indexes

The major currencies

The minor currencies

Overcoming cross-border capitalisation bias


Supranational constraints

Foreign ownership limits

Dual listings

Case study: The MSCI World


12. Maintenance


Rebalancing frequency

Downward-sloping demand-curve hypothesis

Liquidity hypothesis

Information content hypothesis

How radical should changes be?


Avoiding bias

Applying optimisation techniques

Index committee

Removing companies


Financial operating failure

Initial public offerings

Correlation breakdown

Silent indexes

System design

Case study: FTSE Policy Group and Equity Indexes Committee


13. The Commercial indexes


Competitive dynamics

Differences in construction

The S&P/Citigroup equity index

Case Study: Differences in European indexes


14. Bespoke indexes


Reasons for adopting a custom index

Users of custom indices

The politics of forming a new bespoke index

Multinational indices

ADR or synthetic equity indexes

Tax adjusted

Case study: Differing approaches to Socially responsible Investing

Indexes on Bloomberg

Using Bloomberg to build a custom index


15. Tying it all together


The key lessons

Important characteristics of good indexes

Practical application of the lessons learnt

Investors as users of indexes

Areas for further consideration