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Know-How: How to Build an Index

Think you can do better than S&P and Dow Jones? Here's how to get started.

Sanjay Arya, 03/01/2011

This article first appeared in the February/March 2011 issue of Morningstar Advisor magazine. Get your free subscription today!

Do you think the S&P 500 is not a good representation of the market? Want a bogy that's tailored to your investing philosophy? Are you searching for ways to capitalize on the hot ETF market?

Build your own index. You don't have to be a huge institution or own a Ph.D to do it. Just start with these five steps and create a bogy of your own. The process will make you a better investor and (who knows?) maybe even make you richer if an ETF provider licenses it.

1) Determine Your Investable Universe
Define the universe of securities that your index aims to cover. For example, for its U.S. equity indexes, Morningstar includes stocks that trade on NYSE, NYSE AMEX, and Nasdaq. We exclude ADRS, closed-end funds, ETFs, preferreds, and companies not domiciled in the United States. You might want to narrow your universe to smaller or more-esoteric corners of the market.

2) Choose How You'll Select Securities
Eliminate illiquid stocks from your universe. Otherwise, the components of your index won't be tradable. Morningstar excludes stocks that don't trade 10 trading days in the preceding quarter. Also, figure out how much of your universe you want to target. Morningstar's indexes cover 97% of the investable universe.

3) Pick a Method to Weight Index Holdings
This step is crucial, because it influences how your index will perform. Fifty stocks weighted equally will behave differently from the same 50 stocks weighted by size. Commonly used weighting methodologies include:
* Free-float market cap. Each stock is weighted proportional to its market capitalization, adjusted for cross holdings and closely held shares.
* Equal weighted. All stocks are assigned the same weight.
* Fundamental. Stocks are weighted based on fundamental factors, such as revenues, earnings, book value, or dividend yield.

4) Create Your Index Baskets
Depending on your index's objective, create rules for the baskets of stocks that will feed your index. Morningstar has indexes based on market capitalization, style, and sectors. Each type has rules that determine in which index basket a security will reside. For example, the Morningstar Large-Growth Index draws its members from two baskets: large cap, which contains stocks with a market capitalization within the largest 70% of the investable universe, and growth, which holds stocks with strong forward earnings, historical earnings, book value, cash flow, and sales.

5) Rebalance and Reconstitute
If you make it this far, congratulations. You've built an index. But you can't relax. Markets rise and fall; fundamentals change. Your index needs regular maintenance or its weightings will quickly become out of whack.

To retain the weightings you carefully set forth in Step 3, rebalance your index components frequently (ideally once every quarter). Be sure to factor in any major changes in firm-level shares outstanding since your last rebalancing-- a consequence of new share issuance and buybacks.

But rebalancing isn't enough. To ensure that your index continues to represent the universe you've created for it, you have to regularly reconstitute it. Repeat Steps 1-4 every six to 12 months. This is when you'll boot out names that no longer qualify for your index and add those that now do.

Is your index a success? You be the judge. It should accurately cover its intended universe, capture the performance and risk attributes of this market, and reflect the universe's fundamental changes. But the ultimate test might be: Would you invest in it?

Sanjay Arya is Morningstar's director of indexes.

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