This is achieved while avoiding explicit currency and some corporate governance risks. The S&P 500 index, with two thirds of revenues from the US, and the Euro Stoxx50 index, with 46 per cent European revenues, exhibit a more pronounced home bias. At early stages of development, emerging market equity indices tend to be dominated by privatisations and state-owned enterprises, often banks and resource companies, which may not provide the best exposure to the more profitable parts of the economy.
Although the increased popularity of index investing notionally adds liquidity at the index level, this may not be reflected in increased cash market volumes or liquidity, as many index tracking instruments are constructed using derivatives rather than the underlying securities. For investors where liquidity is an important factor, this encourages more investment in indices and can be detrimental to the cash markets. Index investing also lends itself to risk-on/risk-off trades rather than a fundamental approach that looks at individual securities.
As this approach prevails, securities within an index and baskets of indices tend to move in concert. Correlations rise within and between indices and the diversification potential from investing in a ready-made portfolio diminishes.
Frances Hudson is global thematic strategist at Standard Life Investments
