The Theory and Practice of Investment Management: Asset Allocation, Valuation, Portfolio Construction, and Strategies, Second Edition

CREATING A CUSTOM INDEX

It may be that there are no indexes currently constructed that meet the exact needs of the investor. In this case, constructing an index from scratch or combining multiple indexes may very well be worth the time and effort in order to determine the appropriate benchmark. There are several methods that can be employed to create the benchmark index. We will discuss creating a rules-based index as well as using mean-variance frontier analysis to create the appropriate asset class mix within the index.

Rules-Based Indexes

For this exercise, we take a look at an actual index, the rules used to create the index, and how the index can be customized to better suit individual managers. We start by examining the Barclays Capital Global Inflation-Linked Bond Index. This index is a market value—weighted index that tracks the performance of inflation-linked bonds meeting specific credit and issue specific criteria. In the following sections, we look at some of the individual rules governing this index and describe the relevance of each to the above mentioned principles. These rules are reasonably common in creating indexes and can be applied in many situations.²⁹³

Market Type

In a market index, the debt must be domestic government only, meaning that it must be issued by a government in the currency of that country. This rule pertains to Principles 2, 3, and 4 above in that it is a clear description of the type of debt allowed (Principle 3), representative of ...