Passive Equity Investing: Index Construction Criteria

Medium Passive Equity Investing Index Construction

In the context of passive equity investing, index construction is a crucial element for maintaining benchmark alignment and tracking accuracy. A portfolio manager is considering the creation of a new equity index.

This index will comprise companies based on specific criteria. The manager has to assess the implications of using market capitalization, liquidity, and sector representation as the primary criteria for constructing the index.

The manager is particularly focused on how each of these criteria affects the index’s performance and adherence to investment objectives.

Market capitalization ensures that larger companies dominate the index, potentially limiting the representation of smaller companies.

Focusing solely on sector representation allows for better diversification and mitigates risks inherent to specific industries.

Using liquidity as a criterion helps to ensure that the index can be efficiently traded without significant price impact.

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