Investors, or even the general public, dealt with market cap indices like S&P 500 or Hang Seng Index frequently: it’s considered as an indicator of the overall financial market’s performance, the health and strength of the economy activity, the benchmark for performance comparison, or as underlying of ETFs of their retirement portfolio – it is so widely used that many of us has just simply taken them as they are.
But from another perspective, these indices are nothing more than systematic strategies: they are sets of rules on constructing equity universe, applying various liquidity and tradability filters, ranking stocks based on factor (market cap usually), and rebalancing periodically following a specific rule. Just as something similar can be used to construct a complex multi-factor strategies, they can also be used to build something as simple as a market cap index like S&P 500.
Many people already realize that even the most “passive” way of investing like simply buying an index fund involve more or less some extent of active selection and timing: Why buying S&P 500 instead of Hang Seng Index? Why buying stocks instead of bonds? Why buying on this date instead of that day? By deciding on investing on S&P 500 ETF for example, you in fact already made decisions on asset class, country exposure and more and choose to bear the corresponding risk for the potential returns.
But your decisions and the risk you bear as a result can decomposed even further: besides the traditional asset / geographical / industry exposure, you are also exposed to your selection of risk premia factors as a result of you selecting the index as a strategy: market cap index, for example, embed size and momentum factor – a belief that the stocks that outperform in the past (and therefore has larger market cap) will tend to outperform in the future. By bearing this exposure to US, Large Cap, Equity Momemtum factor, you earn the reward of “the market return”.
The index rules, therefore, might be a good starting point to learn more about how this “strategy” actually work by referring to the official index rules. Here are some good starting points: