Customized indices vs. traditional indices: what are the differences?

A stock market index is a portfolio of stocks used to evaluate a sector or an economy. As an aggregator of multiple stocks, its value reflects the prices of all the stocks that comprise it. For example, the value of the CAC 40 index is determined by the prices of 40 selected stocks among the 100 largest French market capitalizations.

A customized index is a custom-made index created by a financial institution to offer an alternative to traditional financial indices. These indices often reference a traditional index but differ in the weighting of their components and their dividend levels. The traditional financial index that serves as the 'base' for the customized index is often mentioned in its name. For example, the CAC Large 60® index refers to the CAC 40 index expanded by 20 additional stocks.

Customized indices were developed by financial engineers from investment banks — known as structurers — to innovate, address risk coverage issues, particularly dividend risk, and minimize competition during bids for derivative products using these indices as the underlying asset.

Customized indices are also known as optimized, proprietary, synthetic, or modified indices.

🏡 Why are they called proprietary?

These indices belong to the issuer—the investment bank—that designed them. They are managed and calculated by companies like Euronext, Stoxx, Solactive, etc., on behalf of their clients who have exclusive rights to exploit them. Only these clients can structure products with these indices as the underlying asset.

⚖️ Weightings

Most traditional financial indices use market capitalization weighting, meaning the stock with the largest market capitalization has the most significant weight in the index.

Customized indices, on the other hand, are often equally weighted (EW), meaning each component of the index represents the same weight.

Smaller, often more volatile stocks therefore have the same weight as large-cap stocks, making customized indices mechanically more volatile. Volatility is a measure of risk, so a customized index may present a higher risk than the traditional financial index it references.

💸 Dividends

The dividend level of traditional financial indices corresponds to the sum of the dividends of its components.

Customized indices, however, present a fixed dividend level, expressed either as a percentage or in points. These two types of dividends represent different risks. In a bearish market, a point-based dividend will penalize the underlying performance more than a percentage-based dividend. The opposite is true in a bullish market.

This dividend level is usually higher than the natural dividend level of the traditional financial index to which the customized index refers. The dividend level of a financial asset has a direct impact on its price: the higher the dividend, the more the financial asset will drop when this dividend is detached. With a higher dividend level, a customized index may present a higher risk than the traditional financial index it references.

👷‍♂️ Why are they designed?

Different customized indices are designed to optimize the financial conditions of the derivative products they underlie.

For yield products — such as Autocall — they are designed with a higher level of volatility through their weighting mechanism, which can result in a better yield.

For participation products — such as Bonus Certificates — they are designed to select the least volatile stocks within a given universe, known as Low Volatility. They sometimes also include a Volatility Control mechanism.

Finally, yield is not the only reason for creating an optimized index. Some are also thematic, allowing investments in topics such as industry, environment, health, or technology.