As a long-term index investor, we need to know whether the index fund that we are investing in has a level of risk and exposure that we are comfortable with. This is especially important now that there are more indices than stocks, and index and ETF providers have been coming up with new indices for retail investors to invest in, such as the recent Work From Home ETF (ticker symbol WFH).

Back to Basics: What is an Equity Index?

An equity index refers to a portfolio of financial assets (could be equities, bonds, commodities) that represents a segment of the financial market. For example, the Singapore Straits Times Index (STI) is a portfolio of the top 30 companies listed on SGX. In contrast, the MSCI All Country World Index consists of companies which are listed from developed countries and emerging markets.

Let’s take a look at some common equity indices and the index construction methodology:

Indices and their construction methodology

Not only do the index providers ensure that the listed companies meet the index factors/criteria, they may also choose to include or exclude listed companies based on profitability, listing history, and liquidity of the shares.

Now that we have the basics out of the way, let's look at the 3 things you need to know about equity indices before you begin index investing:

1. Weighting Method of Indices

There are primarily 2 main types of weighting methods: market capitalisation and equal weightage, along with price weightage. To illustrate this, let’s assume we are investing in a “Singapore Bank Index”, which is composed of 3 banks (DBS, OCBC and UOB).

Understanding Weightage through the imaginary Singapore Bank Index (SBI)

Market capitalisation basically refers to the value of the shares that are available for trade on the stock market exchange. The higher the share price, along with the greater the number of shares available for trade, the higher the market capitalisation. As a result, when the share price increases or when new shares are issued, the weightage will change.

However, for equal weightage, the weightage of the stocks will always be the same within the index, regardless of share price movement.

Because of the different weightage, the risk and performance of a market capitalisation weighted fund and an equal weightage fund will be different, despite having the same underlying shares.

2. Exposure Types for Equity Indices

The exposure type and geographical exposure of the funds let us know how the equities within the asset class are classified, and which category of index investment we are investing in. For example, Apple, which is an American company listed in the US, is categorised under “Information Technology” by the industry sector by index providers. Nestle is a Swiss company listed in Switzerland, and is categorised under “Consumer Staples” by index providers.

Due to the characteristics of Apple and Nestle, it is unlikely that you see them in the same index other than broad-based indices like the FTSE All World Index or the MSCI All Country World index. The more specific the index criteria, the smaller the number of portfolio assets that can be under the index, which brings us to the next point.

3. Risk of Exposure, or lack thereof, in your Equity Index Investment

The most important point for index investors is to understand not just the exposure type and geographical exposure of the index funds, but also the investable universe of financial assets within the exposure.

Any index fund that replicates broad-based indices with wide geographical and sector exposure such as the FTSE All World Index and MSCI All Country World Index are suitable for long-term investing through market cycles. The index providers have a huge range of companies to choose from, and will end up with a diversified and robust portfolio. The index providers will also be able to maintain the performance of the portfolio as existing companies are replaced when they do poorly.

The same cannot be said for indices that have a narrower exposure: the MSCI Japan Index, has done poorly in the past 30 years, as seen from the comparison between MSCI Japan and MSCI All Country World Index Ex Japan (All Country World Index excluding Japan) below.

Low cumulative returns of MSCI Japan relative to MSCI ACWI Ex Japan (Source: MSCI Research)

For Singapore index investors, the STI seems like an intuitive choice to invest in. It is denominated in Singapore Dollars, has many companies Singaporeans are familiar with and has low cost Regular Savings Plans for STI ETFs that makes it accessible to all.

Local index investors have to take note of the narrow exposure of the STI - it is only made up of 30 SGX-listed companies with a huge concentration in finance services and real estate sectors, albeit a lack of exposure in technology companies.

Also, since the index mandate is to only invest in SGX-listed companies, it has to contend with the shrinking number of SGX-listed companies, as large Singapore brands such as Razer, Osim and Sea choose to list overseas.

With a clearer understanding of how indices work and which indices are more suitable for long-term investments, the next step will be to understand how to choose the appropriate funds or ETFs for the index exposure that you are investing in.