Oleg is the CEO of dxFeed, a market data and financial services company. More than 20 years of experience in information technology and finance.
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Indices are generally not considered to be of particular interest to the general public. They are used when they coincide with a specific requirement or area of ​​interest. This could be something like wanting to track how well an asset manager is performing relative to the broader market or establishing how property values ​​have fared in the past before deciding to move to a new area.
However, there is a lot for business leaders to get excited about, especially in a world where we co-create so much data every day and where data is increasingly becoming a commodity in its own right.
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How are indexes used?
Some people like to point to wacky indices, like the Men’s Underwear Index, which claims a broader economic health when men spend more on their underwear. Or the Japanese Haircut Index, which contains economically lean periods supposedly correlated with short hairstyles among Japanese women.
Alternatively, traders have often looked to various luxury goods indices, such as fine art, boat purchases or champagne, to spot irrational exuberance or bubble-like behavior in the underlying markets they trade. The logic is that when these items are overbought, it could signal the spike in other more conventional asset classes. They may even offer them the highly sought-after “top-tick” trade of selling the absolute peak of a bubble before it pops.
In recent years, the sheer amount of discussion taking place online has enabled natural language processing (NLP) algorithms to sift through increasingly rich datasets of publicly available human interactions for use in a growing number of sentiment indices. These are used to gauge the collective feeling of the public on a variety of topics.
What unites the above is the unconventional use of data in the service of gaining new insights, something that everyone can support. We all have problems to solve, and accessing the right data to generate compelling insights is becoming increasingly accessible.
Further, the mass transition of the world to the online domain, while fundamentally disrupting a wide variety of industries and eliminating many incumbents, has also led to the emergence of new business models and ways to make money. Music and video are perfect examples of this.
These industries made the large-scale transition from viewing their products almost exclusively as physical objects to pure data. This has fundamentally recast the power dynamics in production and distribution and has led to a situation where music and video streaming has enabled interested parties to gain a much deeper understanding of how the public interacts with and consumes these products. These are insights that the relevant industries previously had to collect in a much more imprecise and haphazard way.
What are the components of an index?
At dxFeed, we’re particularly intrigued by the prospect of out-of-the-box approaches to data usage and index creation. This can take the form of new approaches to old problems, such as the almost holy grail-like search among portfolio managers for uncorrelated or negatively correlated assets.
Constructing indices with this in mind can provide investors with all sorts of valuable diversification opportunities or even the ability to hedge against unforeseen market events by having a benchmark that won’t go down when the S&P 500 crashes or even does the opposite. For trading venues, these indices hold the promise of offering markets a variety of new types of investment vehicles.
How can business leaders use indices?
To begin with, determining the original concept is paramount. What problem does the index solve for the company? Should it be used for hedging purposes, as the source for derivatives to build on top of, or is it providing the company with a crucial information signal, such as benchmarking ESG performance?
If the idea is not there, make sure you use a reliable data source. Then comes management. What is the company’s strategy for maintaining/rebalancing the index? Again, it should help achieve the company’s objectives rather than unnecessarily drain resources.
Indices are defined by their constituent components and a set of parameters associated with those components. An index can measure the performance of the 42 largest IT companies in the US. One way to do this is to build a portfolio of the stocks of those companies and then calculate their value in real time. In this example, the components are the 42 companies and the parameters are the number of shares per company in the index plus a divisor term for scaling the index value.
Index parameters are calculated during construction to reflect a particular design goal. In our example, that would be a certain share of each company in the index, say by market capitalization. However, since the parameters are static but the market situation is dynamic, the optimality property of the index parameters gradually deteriorates. To fix this, indices need to be rebalanced periodically. The question for index managers is how often to rebalance the index and what procedure to use.
The second aspect of index maintenance is the processing of corporate actions and other relevant events. Each asset class has a series of associated events that require adjustment of the index configuration. Algorithmically, processing these events is simple, but implementing them can give you headaches. One of the most important parts of this schedule is capturing the relevant market events.
Let’s imagine there are 123 AAPL stocks in our index portfolio. If we calculate the actual weight as the dollar value of the 123 stocks relative to the dollar value of the stocks of the other companies in our portfolio, it will fluctuate as the AAPL stock price changes. Suppose, according to our analysis, the optimal weight of AAPL is 30%, but the de facto weight increases or decreases due to stock price dynamics; then we need to periodically change the number of AAPL stocks in our portfolio to achieve the desired goal – a procedure known as rebalancing.
The index must be fully traceable, so the audit should work perfectly; if something happens to the data center, another agency must come into play; if for some reason the principal is stuck at a certain level, investigate the reason.
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