The Importance Of Backtesting And Management

Marion Steward

Oleg is the CEO of dxFeed, a market data and financial services firm. Over 20 years of experience in information technology and finance.

In 2006, British mathematician Clive Humby coined the phrase “data is the new oil.” If the past 16 or so years have revealed anything, it’s that Humby’s pronouncement proved to be spot on. But if data is the new crude, then perhaps index construction can be regarded as the process of refining all that raw material into something much more useful.

Data Tell Stories

The initial explosion in indices can be traced back to the emergence of ETFs in the early ’90s. This accelerated in the aftermath of the 2008 crisis with the dominance of passive investing vehicles.

The Index Industry Association’s latest survey highlights some more recent trends reflected in the index landscape. According to the IIA’s 5th Annual Benchmark Survey, the number of environmental, social and government (ESG) indices increased by 43% between 2020 and 2021 alone. This represents the largest year-on-year growth for an individual sector in the survey’s history.

Think Outside The Box

The data is there, but what you choose to do with that data, how you approach the taming of it into something constructive, that’s what the process of index construction is all about.

An example of this is the University of St. Gallen’s Elite Quality Index (EQx), which focuses on how the elites of a nation and the business practices they promote either add value and foster human development in those regions or adversely affect it. My company, dxFeed, contributed to the project by creating an index management platform, allowing researchers to perform custom deep dives into the underlying datasets.

How To Think About Index Construction

To begin with, it’s important to try and determine the index’s focus. What’s it for? Are you creating a hedging instrument? Are you trying to formalize an investment thesis? Is it for a novel investment product, allowing for exposure to specific sectors? 

After asking the right questions and hopefully narrowing your focus, your next questions should be around the sourcing of data. What’s already out there? What are the costs associated with its procurement? Are there issues with quality? Does it have to be processed in some way? Are you consolidating data from multiple sources? Does it have to be normalized? Do you require redundancies? Just how robust do you need the underlying feeds to be?

The Importance Of Backtesting

Take the construction of an investment product that an exchange wishes to have approved by all the relevant authorities. This is probably one of the most demanding index creation projects as you’re dealing with enormous amounts of data and very strict requirements from all sides.

Backtesting the index product over historical data allows you to observe how it would have performed as an investment vehicle in radically different market conditions. For example, how would a specific combination of stocks weighted in such a manner have performed during the 2008 financial crisis or the Dotcom bubble? How would they have performed in a high-interest rate environment rather than today’s regime? 

Backtests aid in the identification of edge cases where things could have gone radically wrong had the index been a tradable product back then. This allows for the parameters to be tweaked in such a way that the best fit can be achieved over a variety of underlying market conditions. 

Backtesting also allows you to analyze the index along a number of different lines. For instance, how does it perform at radically different timeframes? What are its volatility characteristics? How do different versions of the index’s weighting methodology perform when compared against each other?

Furthermore, far from being just a tool used in the research stages, backtest data is also invaluable when attempting to gain regulatory approval as it documents the various avenues explored in its creation.

Last but not least, backtest data also gets to be repurposed when it’s time to market the finished product. Especially so in the case of financial indices, there’s probably no better way to show off your new index product than to demonstrate precisely how it would have performed historically to prospective investors. 

Management

Finally, for the index in question to have a long and successful reception by the market, special attention has to be paid to its maintenance and management. An index is definitely not something you can set and forget; there’s a great deal that goes into keeping indices up to date and relevant. For this, you can include the maintenance of redundant feeds in order to minimize the possibility of outages, as well as the normalization and storage of historical data. 

Another crucial part of index management is the monitoring of individual components for relevant changes, which may lead to having to routinely reweight and rebalance the index. This is important for it to continue to accurately reflect the aggregated value of the underlying securities.

If the index in question is intended for research purposes, then the creation of an Index Management Platform (IMP) may be necessary. This can only add value to the index and increase the likelihood that it will be used to inform meaningful research. 

In Conclusion

Far from being just interesting ways of aggregating and visualizing data, indices can produce real-world benefits and tangible impacts on everyday life. Well-constructed indices launched at the right time can help preserve investor portfolios in volatile and uncertain climates. They can empower investors to effect change by backing socially conscious companies as in the case of ESG investing. 

Indices can also lead to breakthroughs in public policy as a result of the new information they provide about socio-economic issues. Their ability to effect change is invaluable and becoming all the more relevant in a world where we produce more data than almost anything else, and where the means of harnessing this data is becoming all the more accessible to all. 


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https://www.forbes.com/sites/forbesbusinesscouncil/2022/03/04/index-construction-the-importance-of-backtesting-and-management/

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