Methodology Matters All indexes are not created equally

Methodology Matters All indexes are not created equally

All indexes are not created equally

Better tools for better investing Investors are typically familiar with a handful of indexes commonly used as benchmarks for measuring market performance or as underlying indexes for exchange traded funds (ETFs) and other investable products. Many investors are less familiar, however, with the specific differences in how various indexes are constructed. A clear understanding of index methodology can help investors choose from among the thousands of indexes in the marketplace to help ensure they gain their intended exposures and avoid potentially unexpected outcomes. A simple framework that investors can use to evaluate indexes consists of three broad design categories: 1. Market coverage 2. Construction approach 3. Ongoing maintenance Within these broad categories are several key attributes that can vary widely among indexes and produce meaningful differences in exposure even among indexes that target identical market segments. By understanding these attributes, investors can make more informed investment decisions based on their unique investment objectives and risk tolerance. Market Coverage Representativeness Portfolio Fit ongoing Maintenance Rebalancing Key criteria to consider when selecting an index Corporate actions Weighting Construction approach Objectivity & Transparency

1. Market coverage Whether selecting a broad market benchmark or a specific size, sector or strategy index, investors need to have clear insight into the market coverage provided by their chosen index. Different indexes often take different approaches to determining market cap break points, country assignments, sector classifications and other attributes that influence exposure. Two key criteria that investors should consider are representativeness and portfolio fit. Representativeness: Does the index accurately represent my intended exposure? One of the first issues an investor should consider is whether an index s design delivers accurate exposure to its intended market segment. As part of this assessment, it is important to recognize the objective of the index, whether that is to measure a broad market or to provide exposure to a specific market segment or strategy. For a market benchmark such as a U.S. small cap index or a developed ex-u.s. index is the market segment accurately represented and complete? For a strategy index such as a fundamental index or a low volatility index do the characteristics used to select and weight securities accurately target the intended exposure? More Accurate Exposure to targeted market segments Market coverage

Fully representative indexes deliver more accuracy For example, consider the case of a U.S. investor seeking an index that provides comprehensive exposure to international developed markets. As part of the selection process, investors need to understand which countries are included in the index. Investors might not be aware that some international developed indexes do not include Canada. An investor unaware of this might unknowingly select an index that fails to provide an accurate representation of their intended exposure to international developed markets. Some international developed indexes do not include key countries such as Canada. As expected, countries in Europe and Asia are included in international developed indexes. Included in international developed indexes Not included by some index providers MARKET COVERAGE

Portfolio fit: How does the index influence my intended risk/return profile? The second issue that investors should consider is the overall fit of the index within their portfolio. Does the index provide an accurate exposure that supports the overall portfolio s intended risk/return profile? FOR BROAD MARKET BENCHMARKS: A key design consideration is the overall modularity of the index series. Do the individual market cap-weighted indexes provide the necessary building blocks for accurate asset allocation? For example, are large cap and small cap indexes clearly defined with no gaps and no overlap? This is important because the potential outcome for an investor using an index series with overlap in coverage is a portfolio with an unintended extra exposure to a particular segment. FOR STRATEGY INDEXES: It is critical to understand how the index affects the portfolio s overall risk/return profile. Investors might be attracted to certain characteristics of the index, but they need to have a clear understanding from a portfolio context. Modularity is typically not a relevant feature for strategy indexes, as they are designed to provide focused exposure to securities with specific characteristics rather than to broad, market cap-weighted asset classes. Any potential overlap can undermine an investor s intended asset allocation and produce a risk/return profile that is inconsistent with the intended exposures. By contrast, a modular design with consistent size and style distinctions across the globe helps prevent potential surprises, inadvertent exposures and unintended outcomes. Eliminate gaps and overlaps in market coverage Market coverage

Importance of modularity What it means: Modularity means that the indexes covering each market cap segment are distinct building blocks that can be combined to form a broader index. For example, a large cap index plus a small cap index equals a broad index that represents the entire market. Why modularity matters: Indexes that are not modular may have gaps or overlaps in coverage across market cap ranges that produce inadvertent exposures and can undermine intended asset allocation. Gaps: If an index has coverage gaps, an investor might inadvertently lack the fully representative exposure to the asset class that they intended. For example, a large cap index that omits some large cap securities may leave an investor without exposure to potentially important drivers of the large cap market. Overlap: When there is overlap in coverage across indexes, investors may end up with extra exposure to a particular market cap range. For example, if the lines are blurred between large cap and small cap indexes, an investor might end up with more exposure to one or the other than intended. Modular Index Construction Eliminates Gaps and Overlaps $540.2B Large Cap Large Cap $53.1B $15.7B $5.1B $2B $457M $100.7M $30M Small Cap A non-modular approach can blur the lines of capitalization and create unintended exposures Small Cap Modular Non-modular MARKET COVERAGE

2. Construction approach After determining the market coverage of an index, it is important that investors understand additional details of the construction approach that help determine how easily the index can be replicated and tracked. Challenges in tracking an index can lead to inaccurate representation of the targeted exposure and greater uncertainty about expected performance. These include criteria such as objectivity and transparency and weighting. Objectivity & transparency: Are rules clear, unbiased and readily available? In order to efficiently track an index, investors need to have clear insight into how the index is constructed. A key question is whether an objective, rules-based approach is used, or whether index constituents are determined by the subjective decisions of a committee. A subjective approach equates to a form of active management that is antithetical to the goal of an index in providing transparent market exposures. Active investment decisions belong in the hands of investors and professional investment managers. In general, a methodology that is both objective and transparent makes an index more predictable and easier to replicate, while an index that is subjective and non-transparent is more challenging to track. This is important because difficulty in tracking an index can result in an inability to provide consistent, accurate exposure to the targeted market segment. This added uncertainty can undermine deliberate asset allocation and lead to unexpected outcomes for investors. More transparent and objective indexes are easier to replicate and track Transparent More predictable. Easier to track. Non-transparent Less predictable. Harder to replicate and track. Subjective Objective CONSTRUCTION APPROACH

Weighting: Is the index weighted by market cap or some other approach? How constituents of an index are weighted is a key piece of criteria that has several implications, including emphasis on specific characteristics, turnover and potential tracking error. Traditional market cap-weighted indexes are considered to represent the market for a given asset class as they include the full investment opportunity set within each asset class. Because these indexes always reflect the current market price of each constituent times the number of its shares, they also tend to have low turnover as they do not require rebalancing unless new constituents are added or existing constituents drop out. Other index weighting methodologies have been introduced that are designed to avoid some of the price-driven biases of market cap-weighted indexes or to focus on specific risk factors. Some of these include equal weighting, in which constituents, sectors or a combination have an equal weight in the index; fundamental weighting, where constituents are weighted based on various fundamental characteristics such as revenues or dividends; and factor weighting, where constituents are weighted by their exposure to a specific factor such as low volatility. Indexes that use an approach different from market cap-weighting provide a potential for outperformance relative to the market cap-weighted index. However, there are potential trade-offs to consider as well. These indexes tend to have higher turnover than market cap-weighted indexes, as they require regular rebalancing to maintain their targeted exposure. They also tend to have moderate to high tracking error relative to market cap-weighted indexes, which is to be expected as they have different constituent weights and might not include all of the broader index s constituents. Regardless of which weighting approach is chosen, an investor needs to understand the methodology to be sure they are emphasizing their intended characteristics and exposures. Weighting Methodologies Weighting Rebalancing Turnover Market Cap Index constituents are weighted by size as determined by price times number of shares outstanding Regular rebalancing not required. Annual reconstitution helps an index continue to accurately represent the full opportunity set because companies can move from one index to another. Generally relatively low turnover Equal Constituents, sectors or some combination have an equal weight in the index Regular rebalancing required to maintain equal weighting Trade-off is potentially higher turnover Fundamental Constituents weighted by fundamental characteristics such as revenues or dividends Regular rebalancing required Trade-off is potentially higher turnover Factor Constituents are weighted by exposure to a specific factor such as low volatility Regular rebalancing required Trade-off is potentially higher turnover CONSTRUCTION APPROACH

3. Ongoing maintenance After an index has been built, regular maintenance is necessary to ensure that the index continues to accurately reflect its intended exposure amid rapidly changing global markets. Two of the key issues to consider are corporate actions and rebalancing frequency. Corporate actions: Are actions accounted for using an objective, transparent process? An objective process for handling of corporate actions such as mergers & acquisitions, share adjustments and IPOs helps increase the transparency of an index, thereby increasing the ease of replicability. Corporate actions can have a material impact on index representativeness and resulting performance. In general, the easier it is for investors to know how corporate actions will be handled, the better. Indexes that have a set schedule for these actions provide more predictability and certainty for investors. Mergers & Acquisitions (M&A) Initial Public Offerings (IPOs) Shares Outstanding Spin-offs Corporate Actions A merger is the combination of two companies to form a new company. An acquisition involves an acquiring company purchasing a target company without forming a new company. The initial sale of a company s stock to public shareholders. Changes can occur from stock buybacks, secondary offerings, merger activity, etc. A new entity resulting from the spinning off of assets and equity from a parent company. Rebalancing: What is the approach for maintaining exposure, managing turnover? Indexes that are not weighted by market cap must be rebalanced periodically to accurately reflect changes in the market. Rebalancing is directly tied to turnover, however, and requires a trade-off between potential trading costs associated with turnover and the goal of maintaining consistent exposure. Although some level of turnover is necessary to maintain accurate exposure, it is important to understand that frequent turnover during rebalancing leads to transaction costs, which can erode investor wealth. Rebalance Frequency Broad market benchmarks don t require regular rebalancing, but still need maintenance. Annual reconstitution for these indexes with a combination of quarterly IPO additions and monthly share rebalances provides accurate, comprehensive representation without unnecessary turnover. Strategy indexes are often rebalanced quarterly or monthly to maintain exposure to specific targeted characteristics. Investors need to be aware of the potential turnover of each index as well as any index design choices that may help to limit turnover. Annual Semiannual Quarterly Monthly Annual reconstitution for broad market indexes provides accuracy while helping limit turnover Broad indexes that rebalance semiannually must make sacrifices to avoid excessive turnover Many strategy indexes (ex. fundamental) rebalance quarterly to maintain exposure. Trade-off is potentially higher turnover Some highly focused strategy indexes (ex. factors) rebalance monthly. Trade-off is potentially higher turnover ONGOING MAINTENANCE

Other issues to consider A few additional issues that investors should consider when evaluating an index include: Investability: Are constituents of the index readily available to investors and can they be easily bought and sold? Constituents that are less liquid or not available can make it more difficult to replicate an index, resulting in increased tracking error and potential failure to deliver consistent exposure to the intended asset class. Operational capabilities: Is the index provider established and widely used, with proven operational capabilities and broad clientservices support? Data availability: Is index data published and widely accessible on major platforms such as Bloomberg, Factset, Morningstar, Axioma, Barra, and other systems? Choosing your index Index methodology matters immensely. It is that simple. Investors have an opportunity to be informed about the design attributes of their chosen index to help ensure that their portfolio provides accurate, consistent exposure to their targeted asset classes. Investors who do not fully understand the market coverage, construction approach and ongoing maintenance of the indexes underlying their investments are at risk of a misallocation of capital that undermines their portfolio s intended risk/return profile. It is incumbent upon index providers to help educate investors by committing to the publication of clear, transparent methodology documents that are readily available on public websites. Being educated and informed about index methodology can help investors avoid misguided investment decisions and potentially unexpected outcomes. BETTER TOOLS FOR BETTER INVESTING

About Russell Indexes Russell s index business began in 1984 to accurately measure U.S. market segments and track investment manager behavior for Russell s investment management and consulting businesses. Today, our series of U.S. and global equity indexes reflect distinct investment universes including asset class, geographic region, capitalization and style with no gaps or overlaps. Russell Indexes offers more than three dozen product families and calculates more than 700,000 benchmarks daily, covering 98% of the investable market globally, 83 countries and more than 10,000 securities. Approximately $4.1 trillion in assets are benchmarked to the Russell Indexes as of year end 2012. For more information about Russell Indexes call us or visit www.russell.com/indexes. Americas: +1-877-503-6437 APAC: +65-6880-5003 EMEA: +44-0-20-7024-6600 Russell Investments is a Washington, USA Corporation which operates through subsidiaries worldwide and is a subsidiary of The Northwestern Mutual Life Insurance Company. Russell Investments is the owner of the trademarks, service marks and copyrights related to its respective indexes. Indexes are unmanaged and cannot be invested in directly. This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Russell Investments. It is delivered on an as is basis without warranty. This is not an offer, solicitation or recommendation to purchase any security or the services of any organization. Copyright Russell Investments 2013. All rights reserved. First use: May 2013 CORP-8404-04-2014