In the previous article, we looked at how CFD brokers can use synthetic baskets to attract new and existing traders to their crypto CFDs. A basket that tracks the value of a collection of assets with a strong narrative behind it (like the FAANG stocks, or decentralised finance in the case of crypto) is essentially a custom index product. This week we’re going to dig a little deeper into index construction and methodology for creating thematic baskets, as well as providing further tips on how to offer interesting, narrative-driven synthetic products for other asset classes such as stock and commodities markets.
Panda’s Quoting Engine (PQE) is capable of constructing custom index products from almost anything with a price feed. If there’s a bid/ask on it somewhere out there, we can most probably include it in a custom index for you. As we mentioned last time, in this regard you’re pretty much limited by your own ingenuity. But before we dive into the different themes, let’s have a look at some of the main index construction methodologies you can employ.
Index Construction Methodologies
The S&P 500 (US), FTSE 100 (UK) and DAX (German) are three indices that most people will at least be aware of. All three (and many more of the major global indices), are weighted by market capitalisation. This means that the largest companies have the most influence on the overall value of the index. This is good for investors who want to allocate capital to the leaders in the space, but not so much for those who prefer equal exposure to an entire sector.
A solution to the over-representation of large companies is to use an equal-weighting methodology, which allows for every dollar that’s invested in the index in question, to be equally divided among the individual names the index tracks. An example of such an index is Invesco’s S&P 500 Equal Weight ETF, or the Barron’s 400.
Another popular methodology is to weight the index by price, instead of by market cap. This type of index only considers the price per share of the individual securities included. Two notable examples of such a methodology are the Dow Jones Industrial Average and the Nikkei 225. A common criticism of this type of index is that it’s too vulnerable to the price fluctuations of its individual members.
Finally we move on to the capped indices. Capped indices prevent any individual member from exceeding a certain pre-defined percentage of the overall value of the index. This methodology is useful in preventing individual securities in the index from growing to dominate it. Capped indices also make sense from the perspective of brokers wishing to add index products that don’t have to be constantly recalculated.
It’s All About the Story
Another thing to keep in mind when creating your own custom indices is that the story behind the product is all-important. Particularly for this new generation of traders, who are much more driven by narratives than previous generations. This is partly why Tesla shares have experienced such incredible appreciation over the past few years. Following what’s trending and creating baskets of assets that fit into certain themes, allows your business to have easily investable vehicles that track what people currently care about. In other words, you can do a lot more than just offering a FAANG basket.
We touched upon some of these themes last time. For example, green technology is an ideal basket, particularly for those of you who have a large staple of millennial traders. These indices can include all that’s best from the world of green tech, such as electric vehicle companies, as well as battery and solar panel manufacturers.
You can even create baskets of commodities that are vital to green industries and will be expected to rise in value should the green revolution really kick into overdrive. Commodities such as silver, copper, aluminium and lithium, to name but a few, could be added to a green commodity basket that allows your traders exposure without having to trade the individual raw materials. This is a way to diversify your commodity offering beyond oil and gold, while also attracting new traders.
Agility is Key
The events of the past year have led to a stock market divided into stocks that perform well during lockdown scenarios (Amazon, Zoom, etc.) and those that can only do well during normal business as usual (AMC entertainment, Carnival). With an agile partner like PandaTS by your side, these types of products can be created and brought to market as quickly as the broader investment landscape changes.
In today’s day and age, it’s important not to think of your available assets as a fixed list that you keep adding to, but rather as an ever-changing offering that shifts to meet the needs of new market realities and new traders. In the wake of Covid-19, a pharmaceutical basket that tracks the changing fortunes of the main vaccine manufacturers may also be a useful investment theme for your traders. As long as your ideas are current and you can deploy them in a timely fashion, this type of broader market exposure can pay dividends.
If you’d like to discuss index construction what our Panda Quoting Engine can do for your brokerage, or anything else for that matter, please get in touch. We’re always happy to help.
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