The 5 required components for a tradeable index

Building a better industry benchmark — before an index can be traded, it must be trusted.

Published

Dec 18, 2023

Author

Paul Fortin

All marketplaces are built on trust. From the local farmer’s market to Ebay to the Nasdaq, any market where goods or monies are exchanged must be based on a sense of confidence that both the buyer and the seller will treat every transaction with good faith and adhere to both their tacit and legal obligations throughout a trade.

If trust in a marketplace is broken — or is revealed not to exist at expected levels — participants will take their business elsewhere and the market will eventually cease to exist or fall into a state of stagnation.

Designed to be tradeable

In our last blog post, we discussed the intent for our Exponential Used Vehicle Index to serve as the underlying benchmark for a completely new market: the first derivatives to manage automotive wholesale price volatility. This means our index must not only offer a precisely accurate reflection of the used vehicle market price levels, but also meet other stringent requirements to win the confidence of market participants using it to hedge and trade billions of dollars of exposure tied to used vehicle price levels.

Exponential’s index is designed to be tradeable — a designation that not only sets it apart from all other vehicle valuation indices but also mandates it passes a deeper level of scrutiny.

We decided early on that once our inaugural index was launched on Bloomberg (ticker: AUTO) and other trading and analytics platforms, we would pursue its attestation to the landmark set of 2013 principles set forth by the International Organization of Securities Commissions (IOSCO) that serve as an overarching framework for benchmarks used across financial markets. While our future attestation to the IOSCO framework is not mandatory for tradeable indices, market participants understand that meeting these guidelines ensures the robustness of critical mechanisms around the benchmark and its methodology quality, governance and accountability.

Below are the five required components for a tradeable index — and why it is important that each one is incorporated in our benchmark.

Superior index data

The quality of any one of a benchmark’s components can determine whether it ends as a go-to benchmark for the financial markets — or in a scrap heap at the intersection of Wall & LaSalle streets. The most important aspect of any tradeable index is that it accurately reflects the underlying performance or price movements for the group of assets it is designed to track.

Because our index tracks the used vehicle market, Exponential secured the rights to the industry leading transactional used vehicle wholesale data available today: the National Automotive Auction Association (NAAA) Service Corporation AuctionNet data.

Offering the most robust picture of the used vehicle wholesale market in the US, NAAA AuctionNet data covers more than 80% of all light-duty vehicle auction transactions, with more than 650,000 transactions added each month, totaling close to 80 million total records.

Modern algorithms

While a superior source of data is essential in any premium tradeable index, it’s equally important to ensure that the index is calculated using methodologies and algorithms that best reflect market performance.

Simplistic index algorithms that average all auction data over a given time period will yield an incomplete picture devoid of key factors like vehicle and model mix. On the the end of the spectrum, utilizing advanced AI algorithms will result in black-box index calculations that could erode trust and scare off market participants.

For our proprietary index, we chose algorithms that fell in between these two options as our PhD-level data scientists optimized the index by testing indices built with various algorithms against ABS lease portfolio data, partner portfolio data and other existing used vehicle benchmarks.

The result is an index with an 87% correlation with the Fitch Ratings ABS portfolio residual value gains and losses from 2007 to present, which is well above the 76% correlation achieved by a leading vehicle index incumbent.

Our benchmark also has higher correlations for all five of the captive and bank ABS portfolios where sufficient asset-level ABS lease data is publicly available. This means our index is more closely correlated to the actual residual value performance of the vehicle portfolios of our prospective customers — a critical distinction since our index will enable fleets to hedge residual value risk through our derivatives contracts.

The Exponential Index is able to reach this high degree of accuracy by leveraging a double imputation Hedonic Fisher Index methodology. This results in faster response to market movements and lower week-to-week variability (“noise”), while requiring less data to generate an accurate signal.

Expert index administration

Even with industry leading data and modern data science methods and algorithms, an index can lose value from a hedging and trading perspective if not administered properly. That is why a trusted tradeable index should rely on best-in-class index administrators to calculate, maintain and disseminate the index.

To avoid a potential conflict of interest resulting from the owner of the benchmark also controlling the index calculations, a third-party index calculation agent offers an additional level of independent verification that helps an index meet the highest administration standards.

At Exponential, we chose Solactive as our third-party calculation agent, an industry-leading index provider based in Germany. Calculating thousands of indices daily for trading, risk management and analytical purposes, the company has developed bespoke and multi-asset class benchmarks for ETFs used across the financial industry.

Solactive is already aligned with IOSCO’s financial benchmark principles through compliance with binding German benchmark regulations, which means Exponential gains the additional benefit of a calculation partner that already follows stringent best practices as we begin our own IOSCO attestation in the coming months.

Reputable index governance

While an index’s data, measurement methods and calculation practices are critical to ensuring the quality of its information outputs, it is equally important that a tradeable index is governed with the appropriate oversight.

To ensure we have the proper level of expertise in our oversight function, Exponential Market’s Index Governance Committee includes two University of Chicago professors with backgrounds in index design and manipulation, both of whom approved our flagship index alongside other committee members. With experience working at the Center for Research in Security Prices (CRSP) — which has overseen the creation of tradeable instruments for 16 Vanguard ETFs — our academic experts and the rest of our index committee will be responsible for oversight and change management in case any future methodology adjustments are required to ensure that the index is performing as intended.

Index transparency & accountability

To ensure transparency in the operation of a tradeable index, organizational accountability that ensures proper controls regarding documentation requirements, audit reviews and complaints processes are critical.

These guardrails also ensure that the quality of the index and its associated processes do not erode over time.

At Exponential, our dedication to this aspect of our business includes policies and procedures that ensure we will not revise index values once published and also enables major stakeholders to have input through comment periods before any methodology change. Both of these controls are fundamental for any tradeable financial instrument.

We also document all the decisions and direction from our index governance committee, index calculation agent actions, and any resulting governance and change management systems, as well as publishing all index documentation on indices.exponentialmarkets.com for market monitoring.

All of these measures are critical for the long-term viability of our products and company. Meeting industry best practice tradability standards is the first step in building a lasting reputation so market participants can rely on the Exponential Used Vehicle Index, and future Exponential proprietary benchmarks, to manage the increasing volatility inherent in the automotive market.