All about index investing

• While index providers and index fund managers play different roles, they are equally important to the index investing landscape. As index investing likely continues to grow, it will be important for investors to understand the crucial, yet distinct, roles that these market participants play.
• Index events, including equity and fixed income index rebalances, pose challenges that require careful portfolio management. While equity index rebalances are more flexible in timing, fixed income index rebalances are subject to the intricate dynamics of the bond market, adding complexity to the process.
• There’s nothing passive about index fund management at BlackRock, with PMs making proactive decisions as they seek to deliver the performance investors expect. BlackRock PMs leverage a combination of technology, research, and skill to navigate these events in an effort to deliver precise outcomes for investors in all market conditions.

Market indexes are designed to represent and measure the performance of securities within a defined market, asset class, sector, or investment strategy. Although they are not directly investable — investors can gain exposure to indexes through investment vehicles such as index-tracking mutual funds or exchange traded funds (ETFs) — indexes are valuable benchmarks for investors.

Index providers are responsible for ensuring that the composition of an index reflects its stated methodology. This is done partially through regular updates, or “rebalances,” when changes are made to an index’s holdings and holding weights. Importantly, index fund managers must reconfigure portfolio holdings to match the rebalanced index in order to continue to achieve their index-tracking objective.

Equity and fixed income indexes are two of the most common types of indexes; however, there are notable differences between the two, particularly when it comes to managing the portfolios that track them. For example, equity index rebalances may vary in frequency and timing depending on the index provider, whereas fixed income indexes typically undergo monthly rebalances. The more frequent rebalances of fixed income indexes often result in smaller adjustments compared to equity indexes, leading to lower trading volumes on the rebalance date.

Despite these operational differences, both fixed income and equity index funds are managed by professionals who combine human expertise with technology to pursue the objectives of the funds.

An index is designed to represent and measure the performance of a specific market, asset class, sector, or investment strategy. The S&P 500^® Index, for example, tracks 500 of the largest U.S. stocks by market capitalization. Indexes are used in both index and active investing.

Indexing began in equities but has grown to encompass much more. There exist many different indexes spanning all major asset classes, including fixed income, currencies, commodities and real estate (Figure 1).

Indexes can be broad — like the Russell 2000, which focuses on small-cap U.S. equities — or track narrower segments of the market, including single countries and specific sectors (e.g., technology).

Additionally, active risk benchmarks, or non market capitalization weighted indexes such as factors, thematic and sustainable are becoming increasingly popular with investors as they add additional variables and data points to index methodologies compared to traditional indexes.

Figure 1: Sample indexes by asset class

Index providers, like MSCI and S&P Dow Jones Indices, are responsible for constructing and monitoring a wide variety of indexes. Each provider uses a unique, rules-based methodology to build their indexes. This methodology is used to define the scope of the index, such as which securities or financial instruments are included and their respective weightings.

Index providers monitor not just the market but also regulatory and corporate events for ongoing index maintenance. For example, providers may need to rebalance the index — or adjust the weighting of constituent securities — based on corporate actions (e.g., stock splits) or changing market conditions.

During periodic reviews, index providers may make changes to their indexes.  For example, a provider will remove securities that no longer meet the criteria for index inclusion as outlined in its construction methodology.¹

Alternatively, an index provider may add a security if it becomes eligible for inclusion (e.g., if a private company takes its shares public).

Index providers also contend with macroeconomic events, like geopolitical tensions that result in country-wide or firm-specific sanctions, and may adjust their indexes accordingly.

The index review process for active risk benchmarks tends to result in higher index turnover as a result of the additional complexities of their methodologies.

Unlike individual securities, market indexes aren’t directly investable. Instead, most investors use index funds, which seek to track the performance of designated indexes, less fees.

Index fund managers often engage with multiple index providers. The top index providers for U.S.-listed index ETFs and index mutual funds are shown below (Figure 2).

Index providers license their indexes to asset managers and other financial institutions for a variety of uses, including benchmarking investments.

Index fund managers outline their investment objectives and determine which index benchmarks will best align with those objectives — and, ultimately, the needs of investors.

Figure 2: Top index providers by AUM²

Although index investing is frequently referred to as “passive” investing, index fund management is a hands-on process. BlackRock Portfolio Managers (PMs) and index research teams leverage their deep portfolio expertise and investment skills to consistently seek fund performance outcomes that align with index performance.

Some key elements of the index fund management process include:

• Benchmark knowledge. Maintaining detailed knowledge of index methodologies, anticipating index changes, providing feedback and insights to index providers, and continuously researching index events.
• Portfolio construction. PMs make investment decisions around portfolio structure (e.g., whether to fully replicate an index or hold a representative sample of index securities) consistent with the fund’s stated investment strategy, as well as around cash equitization and corporate actions in index securities.
• Efficient trading. Building smart trading strategies in an effort to access optimal liquidity.
• Performance and oversight. Reviewing the cumulative effect of investment decisions to help identify factors that could contribute to or detract from portfolio performance.

PMs have three primary objectives when trading in connection with index changes for index-tracking portfolios: maintain tight tracking relative to the benchmark index, minimize market impact around the index change event, and minimize transaction costs.

The Index Research Group (IRG) is a team of index methodology specialists who provide insights, analysis, and research on BlackRock’s broad suite of equity index benchmarks (Figure 3). One of the key functions of the group is to create “pro-forma” indexes ahead of every rebalance, or provide projections of what an index will look like in the future based on announced index changes. Having a clear view of these pro-forma indexes is critical in order to position a portfolio such that it tightly matches the index at the precise moment it changes.

Creating pro-forma indexes is no small task. The IRG team managed over 269,000 projections for the November 2022 MSCI rebalance alone. In 2022, the team managed more than 1.5 million projections for the year (Figure 4).

Figure 4: Growth in IRG benchmarks and projections⁴

Because there are many challenges associated with index rebalances, PMs also monitor funds for upcoming index activity. For example, not only do PMs need to understand the rationale behind index changes (e.g., if there is a corporate action, such as a tender offer, taking place), but in instances where they do not need to trade every index holding, PMs must also generate optimized portfolio rebalance orders in an effort to minimize tracking error and cost. Additionally, PMs need to develop cash-management strategies, especially for portfolios with multi-country exposure in which securities may have different settlement dates and market hours.

PMs view each index change as an opportunity to preserve value for portfolios (and investors) in a risk-managed fashion.

To build portfolio solutions for each rebalance, PMs leverage the projections from index providers and evaluate potential trades against a plethora of trading data. Because rebalances are typically announced in advance, there is generally time to complete extensive analysis and actively engage with traders.⁵

In addition to examining portfolio-centric impacts, PMs and traders also consider the broader market ecosystem. For example, PMs headed into a rebalance need to be aware of upcoming macroeconomic events (such as a Fed announcement or a jobs report), corporate earnings releases or shifts in market sentiment that could affect stock prices. To help minimize costs and market impact, PMs must also anticipate the activity of speculative investors seeking to arbitrage and profit from expected changes in the prices of securities being added to, deleted from or adjusted in the index and evaluate the net flows of ETFs and other index portfolios will generate in the index securities.

Analyzing index changes is just one part of managing an index rebalance. PMs must also use this information to determine the most efficient trading strategy to help meet their objectives.

This may involve trading during the continuous trading day (e.g., away from the close) on, in advance of, or after the rebalance effective date. When trading at the close, PMs may utilize limit-on-close (LOC) orders to aim for additional protection against adverse price movements.⁶

In certain circumstances, BlackRock, on behalf of the iShares ETFs, may seek to effect purchases and sales between BlackRock clients (including across iShares portfolios), known as “cross-trades.” For example, if a stock is being removed from Fund A and added to Fund B, those trades may be offset through an internal crossing mechanism, thus reducing overall trade size and resulting impact on the underlying market.

Fixed income ETFs allow investors to access broad or targeted areas of the fixed income markets in a transparent and low-cost manner. However, there are structural nuances to the bond market that can add complexity for PMs seeking to drive consistent performance outcomes. These include:

• Opaque pricing. Bonds are primarily traded over-the-counter (OTC) between two parties (e.g., a broker-dealer and an investor, typically an institution). Transparency into the cost of trading or pricing of bonds can be low (versus on a centralized exchange where all trading activity and data is publicly available) as a result.
• Monthly new issuances. Every month there are new bonds to be considered for index inclusion.
• Fixed lifespan.  Bonds have a fixed maturity date, which can impact their eligibility for inclusion in certain indexes.
• Credit events. Bonds that have credit ratings that fall below Investment Grade (i.e., “Fallen Angels”) are typically managed out of Investment Grade indexes by month-end of the downgrade. Conversely, bonds that are upgraded (i.e., “Rising Stars”) will typically be included at month-end.
• Low liquidity. Most bonds trade infrequently. For example, in 2022, investment grade corporate bonds’ daily turnover was estimated at 0.27%.⁷

Unlike stock indexes (which rebalance only a few times each year), most fixed income indexes rebalance monthly to capture changes in the bond market described above. These frequent changes mean that fund managers seeking to track these indexes must plan for portfolio adjustments every month.

Managers of index-based ETFs strive to track the performance of an ETF’s underlying index as closely as possible. However, the unique attributes of the bond market can make it challenging for a bond fund to attempt full replication of bond indexes, which can include thousands of securities. Instead, PMs may use a representative sampling strategy. This approach seeks to deliver the risk and return characteristics of the index by holding a subset of the index’s securities.

To do this, the PM divides each index into groups of bonds with specific risk factors (such as maturity, credit rating or sector), then selects bonds from each group to build a portfolio that reflects similar characteristics to its underlying index, including yield and duration, in order to replicate the index returns as closely as possible (Figure 5).

The creation and redemption mechanism can help PMs to efficiently manage the rebalancing process throughout the month. Most creations and redemptions of fixed income ETFs occur “in-kind,” which means the ETF and the authorized participant (AP) exchange bonds in lieu of cash for ETF shares. When ETF shares are being created or redeemed by APs, the PM confirms that bonds entering or exiting the fund will help the ETF track its index.⁸

Figure 5: Example of sampling⁹

iShares fixed income ETFs are managed by global teams of fixed income professionals who have deep trading and portfolio management expertise (Figure 6).

BlackRock PMs utilize a combination of technology, index research, and skill to pursue investment objectives while balancing tracking error, liquidity, and transaction costs.

BlackRock’s flexible portfolio management process allows fixed income PMs to proactively, dynamically, and efficiently execute changes in ETF portfolios as the market evolves. For example, to account for new additions to an index, PMs will often participate in the new issue market, adjust portfolios throughout the month (instead of rebalancing on a single day at month-end), and avoid situations that may result in forced buying or selling.

By participating in the new issue market, BlackRock PMs can acquire a bond when it is issued rather than at month-end when it is added to the index. This can offset some of the transaction costs (like the bid-ask spread) of buying the bond in the secondary market after issuance. This process works because ETFs generally have some flexibility to hold up to a certain percentage of non-index names.