Index Methodology Overview
This paper was prepared to assist subscribers/investors with an understanding of the investment concepts behind the construction and use of the FATI® Sector/Group Index.
The investment world is more data dependent today than ever before. This applies to both technical or fundamental data. The individual stock universe is comprised of approximately 16,000 stocks, of which 8,000 have quasi-reliable technical and fundamental data available. Even a universe of 8,000 stocks is extremely large and very hard for any investor to manage.
One of the risks with large amounts of data, of any type, is its quality. If we use low quality data, it could create incorrect outputs used in your investment decision process. There is an old adage that applies here and most have heard it before: Garbage In – Garbage Out. The quality of data and the ability to manage this data is paramount in the investment management process.
Many of the available Sector/Group Indices have, what is called, ‘limited participation’. Some of the industries groups contain only one or two stocks. The FATI® Sector/ Group Index is designed to maximize the number of issues in each industry group. For example, a major index provider has an index with 60 industries and an average of 8.3 stocks per industry. If you look closely you will find over 10% of the industries are comprised of only one or two stocks. Hardly a representative sample. The FATI® Sector/Group Index averages over 44 stocks per industry and no less than 6-7 stocks on average in an industry group. This gives investors a more accurate representation of each industry. The index also broadens the number of sectors from the industry average of 10 to 17 sectors. This was done to improve the granularity of the index and make it easy to identify investment opportunities.
Influential Factors on the Markets
It is a well-known fact approximately 90% of the volume in the equity markets come from institutional investors. These investors include mutual funds, pension plans, insurance companies and hedge funds Due to the large size of the portfolios they manage, it may take weeks, if not months; for them to build a position in a stock. Remember, these investors try to buy or sell in a stealth manner to avoid tipping their actions and having the price pushed up or down before they have finished acquiring or disposing a position.
Since institutional investors have such a significant influence on the market, it only makes sense to focus on the stocks they watch and trade. We conducted a poll to determine if there were a common, and simple, set of criterion which could be used to narrow a list of over 8,000 stocks. At the same time, try to determine what the average investment manager’s universe of stocks is comprised of. Institutional analyst’s standards are high when it comes data requirements. If those standards are missing from the data of a company, they won’t consider the company for investment potential. Remember Data Dependence from above. ‘Garbage In – Garbage Out’.
The Poll and Results
The poll was conducted from a random list of investment managers. Armed with the data collected from the investment managers a plethora of test screenings were performed. Each screening was reviewed to determine the data available, data completeness and data quality, both fundamental and technical. After exhaustive testing, a final list of criterion was selected. The final screening using the selected criterion was performed and compared to several investment manager’s universe of stocks. The results showed, on average, the final screen captured 86% of their universe of stocks. Some higher some lower.
Below is the final criterion used in the construction of the FATI® Sector/Group Index.
- Average Daily Trading Volume >= 100,000 shares
- Current Price >= $5.00
- Number of Analysts in Average Broker Rating >= 2
- Market Cap Valuation >= $100 million
The index is updated once a month using the criterion listed above. In any given month as many as 20-300 stocks may be added and/or deleted from the index. The number of issues in the index has ranged between 2,500-3,000 stocks. By narrowing the number of stocks in this manner, the fundamental and technical data was more plentiful, more accurate and more complete.
Putting it All Together
Knowing the key concepts and the criterion used in the construction of the FATI® Sector/Group Index, let’s put it all together and answer the question.
The index provides investors with:
1. a list of stocks institutional investors watch and trade.
2. a higher quality Sector/Group structure for better investment decisions.
3. market capitalizations ranging from Mega Caps to Nano Caps.
4. the elimination of low priced / low quality stocks with poor quality data.
5. simple maintenance of the index and fundamental data. Download and Use.
One Last Thought
There are two generally accepted approaches to investing. Fundamental and Technical. Which is better is not up for debate here, but instead consider the following;
Fact, the majority of institutional investors purchase companies based upon strong fundamentals and earnings.
Professional Traders focus on technical indicators, patterns and news events to determine when to buy or sell a stock.
First, use the FATI® Sector/Group Index to focus on the stocks institutional investors are watching and trading. Next, screen for companies in the Index with strong fundamentals and earnings. Lastly, use technical analysis to determine when to buy or sell the fundamentally screened stocks.