Paul: [00:00:01] Welcome to the second season of Index Ideas from FTSE Russell. I'm Paul Amery, your podcast host.
In this podcast we look into how FTSE Russell indices are built and why. We explore index ideas that can help you address real-world investment challenges. As a reminder, you can't invest in an index and so the concepts that we discuss in the podcast are not investment advice. So any reference to potential investment strategies is intended for informational and educational purposes only. In the first episode of season two of the podcast, I'm joined by Arne Noack, who is head of equity and multi-asset indices, Americas, at FTSE Russell. Arne, welcome to Index Ideas.
Arne: [00:00:42] Paul, really looking forward to the conversation.
Paul: [00:00:45] Arne, FTSE Russell has nearly 40 years of experience in indexing global equities. How do we measure the global equity market?
Arne: [00:00:52] Yes. So, measuring the global equity market: essentially what that means for us as well as all key index providers, is by aggregation of the global equity universe, weighted by the respective market capitalisation and often adjusted by free float.
So essentially what that means is you look at all of the listed equity stock in the market on the different bourses around the world. You sum them all up and then you see how large are the companies, how large is the free float of the different companies in relation to each other? You assign more weight to those companies that are bigger and less weight to those companies that are smaller. That's the basic summary of it.
Paul: [00:01:40] Thank you. Arne. So FTSE Russell's flagship global equity index is called the FTSE All-World Index. Who uses it and how?
Arne: [00:01:48] So our FTSE All-World index. I'm glad that you point that out Paul, because it is in fact one of our more famous benchmarks. But you know the comments apply for essentially all of our FTSE Russell indices, be that under the Russell brand or the FTSE brand. And they're used really by a multitude of investors. Those could range from active portfolio managers, active fund managers who simply seek to benchmark the performance of their own portfolios in relation to a global equity portfolio. Or it could be so-called index fund investors who very simply want to have a cost-efficient and clear and transparent way of allocating client funds to the global equity markets, and by doing so, do that in accordance with the index. So, again, as I said before, upweight the larger companies and downweight the smaller companies in order to generate a portfolio performance for their investors that is simply aligned to the global equity markets, as measured by the FTSE All World.
Paul: [00:02:47] The FTSE All-World index includes both developed and emerging markets. What's the split between those two categories, whether it's in terms of the number of markets or capitalisation or number of stocks?
Arne: [00:02:58] So the significant weight is still to developed markets. Out of the developed world actually the US still dominates quite significantly. But those weights are fluctuating over time. So that's another feature I would say, of a global equity universe: global equity indices reflect the relative performance of the different regions versus each other. So over the last half year or so, where we've seen a little bit of a static performance across the US and a significant performance, relative performance in developed as well as emerging markets relative to the US, the relative weights of those non-US [markets] are starting to increase ever so slightly.
Paul: [00:03:52] Arne, the FTSE All-world index includes large and mid-cap stocks from 48 countries. How do we measure size for this purpose? Is it by individual country? By region? What's the way FTSE Russell does it?
Arne: [00:04:03] So we split the global equity universe into different regions: into nine regions in particular. So the US is a region, Canada is a region. Then we look at developed Europe, emerging Europe, Japan, China, Asia Pacific, Latin America as well as Middle East and Africa. And so essentially what that means is the stocks within each of those regions are grouped amongst each other. The top 70% market cap names are then considered to be large-cap names, the next 20% to be considered mid-cap names, and then the rest are small and micro-cap names. So essentially what that also means, if you're a European stock of a certain size, you could be considered a large-cap. If you were hypothetically listed in a different region, you could fall into a different bucket. So it is important to understand that the ranking is a relative one within the respective region.
What I would also say, Paul, and this is I would say a little bit index lingo-specific is as an index investor, as a benchmark, you have to pay a little bit attention to the nomenclature of an index, because you're absolutely right, the FTSE All World Index represents large- and mid-cap stocks. But we also have a very, I would say, very similar index that we call the FTSE All Cap index. And that All Cap index does in fact include small-cap names. The performances are very similar but not equivalent. So those little nuances in the name of the index can actually be indicative, or typically are indicative for key differences in the methodology, which will lead to slight differences in portfolio composition and performance.
Paul: [00:05:47] And presumably Arne, that also applies to the way indices are labelled across different index firms, you can't automatically assume that the way FTSE Russell does it is the same as other index providers measure the global equity market.
Arne: [00:05:59] Yes, that's correct. So let's say there is no global authority that dictates to index providers how to name the indices. Obviously, as an index provider, we always seek to have the maximum transparency and clarity in our naming. Clarity often can be subjective. So what we think is crystal-clear might not be immediately intuitive for everyone. So I would urge everyone to be in touch with us in case there is any doubts. But to give you a name, as we discussed, our FTSE All-World Index, which contains the word “world” in it, we truly think is reflective of the world's equity market. As we said before, it does contain a majority of developed markets, but also a significant portion of emerging markets. And I would say that use of the nomenclature “world” isn't always consistent across all index providers, and not all world indices do, for example, contain emerging markets. So that's just sort of from a very high level, one of the key differences that investors and benchmarkers can encounter. But then also when you look a little bit more into the detail, what also clearly really, really matters is, for example, how index providers do classify certain countries.
Arne: [00:07:13] One of the key differences between us and other index providers in the past, and still currently, is the classification of Korean equities, which we consider to be part of the developed market universe, whereas other index providers may choose to group Korean equities and Korea as a country still as an emerging market. There can be some additional nuances from sort of below emerging markets in terms of, let's say, advancements of frontier markets. But, you know, index providers from time to time do move countries up and down the ladder between emerging and developed, developed and emerging, emerging and frontier. And so to keep up to speed with that and really know what is contained in your index, I would say is key if you're considering to be an investor in an index fund, for example. And for that we really want to be here, engage in conversations, have conversations such as this one to make sure we provide the maximum degree of transparency possible.
Paul: [00:08:13] Arne, when we started indexing the world in 1987, there were 24 countries in the index, which was then called the FT-Actuaries All World Index. Now there are 48 countries in the FTSE All World. What determines whether a country is eligible for inclusion in the index?
Arne: [00:08:30] So FTSE Russell as an index provider, or generally the key index providers in the world, always publish the rulebook that underlies the construction methodology of any index. So for those investors who are keen to understand that, those rules, that book is published transparently. It is easy to read. It's easy to understand. And after having digested it, you will really clearly understand any given index and what determines the inclusion thereof. So as we said before, for example, the FTSE All-World index is designed to be representative of the large- and mid-cap equity universes from a global perspective. And when we say global perspective, in this instance, it's actually developed and emerging, but not frontier markets. So over time, essentially what is considered to be a developed and emerging market, that understanding has evolved, or let's say, the market's availability to invest in those equity markets has emerged. Hence that sort of development leads to a bigger inclusion of countries in the given index. FTSE Russell, we actually publish a Quality of Markets Matrix, which seeks to assess and make transparent how we see the different markets. So what influences that, for example, is how easy is it to trade equities in a given market? How easy is it to trade the foreign exchange in a given market? In other words, how, from the perspective of a possible index portfolio manager that is based, let's say in the US or anywhere in Europe or anywhere in the world, how easily can they construct a portfolio that looks and feels like that index?
Paul: [00:10:18] Arne, how do we make changes to the FTSE All World index’s membership, and what's the role of the country classification watch list?
Arne: [00:10:25] So changes can occur in two ways. One is a little more organic where let's say the rules stay unchanged. And you know, as markets develop as there's IPOs, as companies come to market with the equity offering, those companies may be included in the indices if they meet certain thresholds in terms of liquidity, in terms of market capitalisation. So essentially, let's say, that's general index renewal as the equity markets develop, one. And the other one is a little bit more proactive where we intend to engage in what I would generally refer to in rule hygiene. So let's say if there is developments, as I said before, for example, a frontier market updates legislation or processes, or maybe in a developed market there are restrictions that get introduced. So our index team and index policy team review the applicability of our rules on an ongoing basis and engage in conversations with our external advisory boards to see that sort of our application and understanding of the rule set in the current realities of the equity markets still remains relevant and applicable.
Paul: [00:11:31] And so we make changes to the country constituents as well over time when countries meet certain accessibility criteria.
Arne: [00:11:39] Yeah that's correct. So, as I said before, one of the more famous examples is Korea that previously, all index providers saw as an emerging market. And then FTSE Russell decided that we saw sufficient advancement in terms of the developments of the country's equity market to be considered a developed market. And more recently, a similar situation for Vietnam, which previously was considered a frontier market. And in October of last year, where the announcement was made by FTSE Russell that a review has been started or they're being considered for an upgrade into an emerging market later this year, subject to a review this March. So it's an organic process and it does evolve over time.
Paul: [00:12:25] Thank you for explaining that Arne. What's the role of the advisory committees? Who sits on them and what kind of feedback do they provide? And do they have just an advisory role or who takes the ultimate decision on index changes?
Arne: [00:12:36] So the decision still rests with FTSE Russell and essentially our internal governance processes in terms of what we deem to be relevant in terms of decision-making, to be a good benchmark and arbiter between different potential interests that are being brought towards us from the different market practitioners. As I said, Paul, the different advisory boards are comprised of different market practitioners from, let's say, the sell-side—so banking trading desks, for example—
but also the buy-side, those could represent active fund managers, passive fund managers or index fund managers or even academics from different areas of academia. And obviously, when you have a dispersed group of individuals who provide the opinion and who are solicited and actively we invite them to share their opinion with us in terms of what they think should happen within any given sort of set of circumstances, you could have a pretty diverse set of outcomes. People for sure have different views in relation to what country should be considered developed market, what should be considered an emerging market. And so the role of the arbiter and let's say the ultimate decision-making still rests with FTSE Russell in this process.
Paul: [00:13:56] Okay great. And finally Arne, obviously you mentioned the role of the US. You know it's got a big weighting in the FTSE All-World. What demand are you seeing in product development terms for variants of the FTSE All-World that either exclude the US or give it a slightly lower weighting?
Arne: [00:14:13] Predominantly, we see a lot of interest for our global benchmark. It's a very convenient way to allocate capital to the global equity market and be very, very diversified across regions, even though you have a fairly significant weight to the US. But in order to potentially supplement that kind of core investment, our regional benchmarks that, for example, focus specifically on European equities or focus specifically on Latin American equities, or focus on global equities excluding the US, in order to provide a potential counterweight to what could be a fairly substantial overweight to US American equity markets, those kind of, let's say, regional slicing and dicing of indexes is extremely relevant for our investors, for our clients, especially from the index investing world. And yes, the global ex-US benchmark is very popular both within the US, as I said, to provide a potential counterbalance to a significant home bias, but also in the European equity markets. And that sort of dynamic of taking a significant chunk, putting that on the side and having sort of a benchmark that represents the opposite of that as a counterweight can be applicable in different regions. That could be something like Latin America ex-Brazil, that could be emerging markets ex-China: not by way of excluding a company because of a certain value judgement or anything, simply to give the portfolio manager or the investor a better ability, a greater ability to steer and fine-tune allocations within the portfolio.
Paul: [00:16:07] Arne, thank you very much for joining me. And that's it for this episode. If you've enjoyed the conversation, then please follow us and give us a positive rating or review on your podcast app of choice. If you'd like to get in touch with the show, you can do that via the email
[email protected]. But for now, from me, Paul Amery goodbye.
