Indices are critically important in today's investment markets, but an index is never just an index. Explore how good indices are created, what makes them work and why they are an essential tool to help investors.
Since the 1970s, investors have turned to indexing as a performance benchmark and a tool to support investment strategies, pouring more than $1.3 trillion in assets into index-backed exchange traded funds, mutual funds and other products. But what is an index? What does it do exactly? How is it decided which securities are included? And why might indexing as part of an investment strategy offer such compelling long-term results?
We look under the hood of indexing to explain how and why indices work, why it is important to understand an index before choosing a related investment vehicle, and how indices and index providers differ from one another.
Your questions
1. What is an index?
Generally speaking, an index is an indicator or measure of something. In simple terms, in the world of investing, an index is a hypothetical portfolio of securities designed to represent an asset class, market, or market segment.
1.1 How are indices used?
Indices play an important and informative role at every step of the investment process. Economists use them to analyse economic trends, and investors make decisions based on economists’ forecasts. Institutional investors use indices to conduct risk analysis, develop investment policies, and create asset allocation strategies. Nearly all types of investors use them to evaluate the performance of their investment portfolios. Indices are also used as a basis for investable products such as mutual funds or ETFs that allow for passive investment in a specific market, market segment, or asset class.
1.2 How are index constituents chosen?
To deliver an unbiased, complete view of a given market, the method by which an index’s constituents are selected must be free of subjectivity, as the index should include all of the practical opportunities available in the market. An objective, rules-based formula for determining which companies become components of the index (as opposed to a hand-selected sample) is a critical component of the construction methodology of a truly representative index.
For example, if an index designed to represent the large cap segment of a given market omits some of the large cap companies readily available to market participants, and that index is being used to define the basket of stocks from which an investment manager may select, the resulting large cap portfolio could be left without exposure to important drivers of the large cap market.
2. Calculating index values and performance
2.1 What is an index value?
Differences in how index values are calculated can occur depending on the index weighting scheme. For the sake of simplicity, we will explain the calculation of market cap-weighted index values.
As prices and market values of the stocks within an index rise and fall, the index reflects this movement using a series of index values. Index values are calculated and published daily after the market closes, and in some cases they are calculated in real time. The change in an index’s value from one point in time to the next represents the performance of the index (i.e., the performance of the market/segment it is designed to measure).
2.2 Calculating index values
Below is a hypothetical market cap-weighted index that includes five constituents.
| Stock name | Stock price | Shares included | Market value | Index weight |
|---|---|---|---|---|
| A | $3 | 50 | $150 | 15% |
| B | $1 | 50 | $50 | 5% |
| C | $7 | 70 | $490 | 51% |
| D | $9 | 20 | $180 | 19% |
| E | $10 | 10 | $100 | 10% |
| Total market value | $970 | 100% | ||
The market value for each stock is calculated by multiplying its price by the number of shares included in the index, and each stock’s weight in the index is determined based on its market value relevant to the total market value of the index.
Stock A, for example, has a share price of $3, and there are 50 shares of this stock in the index, so its market value is $150 ($3 X 50 shares = $150).
The total market value of every stock in the index is $970, so Stock A’s weight, or representation within the index is 15% ($150 / $970 = 15%).
When an index is first created, a starting (base) value is chosen. In our example, we will use 100 as the base value. Now that we have the total market value of our index and our base value, the next step is to determine the index divisor by dividing the total market value of the index by the base index value of 100 ($970 / 100 = 9.7).
Each day, as the market values of the stocks in the index fluctuate based on changes to their prices, the new total market value of the index is divided by the same divisor (9.7) to produce a new index value:
| Day | Index total market value | Divisor | Index value |
| Day 1 | $970 | 9.7 | 100.0 |
| Day 2 | $1010 | 9.7 | 104.1 |
| Day 3 | $995 | 9.7 | 102.6 |
| Day 4 | $1000 | 9.7 | 103.1 |
The divisor remains constant until the index constituency changes. For example, if a stock is delisted or a stock split occurs, the divisor will be recalculated to be reflective of the new index membership.
2.3 How are index values used to calculate performance?
Index performance between any two dates can be calculated by dividing the ending index value by the beginning index value as follows. Using our hypothetical index as an example:
Day 1 index value = 100.0
Day 4 index value = 103.1
((103.1 / 100) -1) x 100 = 3.1%
2.4 Why do index values vary so widely across indices and index providers?
Comparing the values of indices designed to measure the same market or market segment can be daunting, and in most cases irrelevant. Indices can be started, or “launched” at different points in time and with different base values, so it is important not to get hung up on the values themselves, but rather the growth (or decline) of those values over time.
For example, if Index A had a base value of 100 in January of 2015 and that value increased to 150 as of January 2018, the index value increased by 50% over that 3-year period.
Index B measures the exact same market, but its starting base value was 1,000 in January of 2015, and its value grew to 1,500 as of January 2018. This value of this index also rose 50% over the same 3-year period.
Comparing their January 2018 values of 150 and 1,500 is irrelevant, as they were started with different base numbers. It’s their performance, not their values, that should be compared.
2.5 Why do index values vary so widely across indices and index providers?
Comparing the values of indices designed to measure the same market or market segment can be daunting, and in most cases irrelevant. Indices can be started, or “launched” at different points in time and with different base values, so it is important not to get hung up on the values themselves, but rather the growth (or decline) of those values over time.
For example, if Index A had a base value of 100 in January of 2015 and that value increased to 150 as of January 2018, the index value increased by 50% over that 3-year period.
Index B measures the exact same market, but its starting base value was 1,000 in January of 2015, and its value grew to 1,500 as of January 2018. This value of this index also rose 50% over the same 3-year period.
Comparing their January 2018 values of 150 and 1,500 is irrelevant, as they were started with different base numbers. It’s their performance, not their values, that should be compared.
2.6 What is the difference between a price return and total return index values?
A price return value measures the changes in the stock prices and market values of the index constituents over time, as shown in the example above.
A total return value measures the changes in stock prices and market values as well, while also capturing the dividends paid to shareholders by the companies in the index by reinvesting the dividends. The dividend reinvestment and compounding is done at the total index level, not at the security level.
2.7 What is the difference between a Laspeyre index and a Paasche index?
Whether an index is a Laspeyre index or a Paasche index describes how changes to share quantities are reflected in the calculation of index values.
In a Laspeyre (or base-weighted) index, any changes in the prices of the underlying stocks are reflected in the calculation of the index value on a daily basis, but changes in share quantity are not factored in until the following day’s calculation.
In a Paasche (or current-weighted) index, any changes in the prices of the underlying stocks are reflected in the calculation of the index value on a daily basis, and share quantity changes are factored into the calculation of the index value same-day.
Neither method is subjectively better than the other, and both types of indices are used in the industry. Both have their advantages and tradeoffs. For example, a Paasche index may be more up-to-the-minute than a Laspeyre index, but it can tend to overestimate values as well (compared to a Laspeyres, which can underestimate).
3. Considerations for choosing an index
In evaluating the appropriateness of an index, investors should take a holistic approach and explore, for example, how well the index strategy suits their objectives, risk constraints, and beliefs as well as how well it complements or interacts with the allocations designated across the rest of the portfolio. The index attributes you should consider can also depend on how the index will be used.
3.1 Indices as benchmarks: Why index selection matters
| Attribute | Rationale |
|---|---|
| Comprehensive representation of the intended market or market segment | When utilizing indices to define the mix of asset classes appropriate for a plan or investment portfolio, it is important that each index deliver accurate and comprehensive representation of its intended market segment. Omitting eligible securities from an index can lead to unintended consequences such as errors in the asset allocation structure of the total portfolio. Complete market coverage is also important when using an index to benchmark an actively managed investment. Comprehensive coverage of the entire investable opportunity set provides an appropriate basis from which to accurately distinguish alpha from beta. In other words, measuring the success of an actively managed investment using an index that fails to offer complete coverage of the assigned asset class can result in an unfair evaluation of manager performance. |
| Transparent and objective index construction | A transparent and objective approach to index constituent selection provides a more accurate, unbiased representation of the market it is designed to measure rather than a subjective, committee-based method. Objective rules allow investors to understand and potentially anticipate why and when changes are made to the index. Subjective, committee-driven membership selection can result in delayed inclusion of newly available opportunities that can impact an index’s representativeness. If the index is not truly representative, it can not be used to define appropriate asset allocation, nor can it be trusted as an effective means of gauging investment performance as compared to the overall market or market segment. |
| Regularly rebalanced and maintained | Regularly scheduled rebalances and clearly stated maintenance rules to adjust for more frequent changes such as those due to corporate actions like spin-offs and IPOs ensure that the indices are always aligned with market conditions. This allows for accurate and up-to-date measurements of the markets and market segments. |
| Modular structure with no gaps or overlaps | Index families designed to represent broad markets as well as more granular market segments should be modular in design. Modular indices can be use as building blocks, offering a precise picture of the market and its segments. This enables accurate asset allocation implementation without unintended over-/under-allocations to small, mid or large cap asset classes. An investor allocating specific portions of their portfolio to large and small cap, for example, should be able to rely on indices to clearly differentiate between these market segments with no gaps or overlaps. If the market cap coverage ranges of the large and small cap indices overlap significantly, the investor could experience unintended overexposure to the mid cap market segment, undermining their intended allocations to large and small cap. |
3.2 Indices as the basis for index-tracking investment products: Why index selection matters
| Attribute | Rationale |
| Representative | Since the goal is to gain access to a particular market or market segment, the index should aim to be as representative of this market segment as possible. |
| Cost efficient | Transaction costs are incurred by passively managed investments when changes to the underlying index constituents and weights are made. It is important that the index balances its goal of being representative with the need to keep turnover costs manageable. |
| Objective and transparent | Because the investment is replicating the index, it is important that the rules that govern the index design and calculation are published openly and transparently. The investor should be able to understand and anticipate changes to the index. If not, replicating the index can be difficult and unintended tracking errors may occur. |
| Investable | The index should limit its holdings to those readily available to the investor. For example, index weights should be calculated using float-adjusted market cap, meaning the index should only include the shares that are freely available for purchase by the average investor rather than those held by employees or other investors who are restricted from selling their shares. If shares not available to public investors are included in the index, replicating the index can be difficult, and the demand for shares from investment funds replicating the index can actually cause unnatural stock price spikes. |
3.3 Why is index governance important?
it is important for an index provider to have a formal governance system in place to proactively evaluate their indices to ensure they are responding and adapting to the evolving market. Meanwhile, consideration must also be given to the fact that frequent implementation of index methodology enhancements can be burdensome to the end user. The index governance process must weigh the pros and cons when contemplating changes that may have downstream impact on index users. Methodology changes and other index enhancements should be reviewed, considered, and approved within a well-defined governance framework that draws from internal expertise as well as external independent committees of leading market participants.
4. How are indices weighted?
Indices constructed to measure the characteristics and performance of specific markets or asset classes are typically market cap-weighted, meaning the index constituents are weighted according to the total market cap or market value of their available outstanding shares.
In market cap-weighted indices, a company’s representation within the index is based on its size, and its performance contributes to the performance of the overall index proportionately.
In other words, the company with the largest market cap will represent the largest weight in the index, meaning mega cap companies like Apple will impact the performance of the overall index more than a small cap company will.
This method of weighting index constituents remains the most commonly-used today. Despite the development of hundreds of alternatively-weighted indices in recent years, market cap-weighted indices remain relevant—they are utilised to measure changes equity markets globally markets and measure changes in the overall size of the market(s) over time.
4.1 What does it mean for an index to be float adjusted?
The original market cap-weighted indices included all of a company’s outstanding shares. This method is problematic in cases where companies have shares that are not fully available for trade on the open market, such as government-held shares or large privately-controlled holdings. Float adjusting an index means that only shares that are readily available to the public are represented in the index.
4.2 What are alternatively-weighted indices?
There are a number of alternatively-weighted index construction approaches to complement traditional market cap-weighted indices. In alternatively-weighted indices, constituent weights are determined independently of market measures of company size (i.e., market cap). These indices are designed to target specific objectives such as reducing risk or improving diversification. Alternative weighting mechanisms include equally weighting index constituents and basing weights on fundamental criteria such as revenue, cash dividend rates, and book value.
4.3 What are factor indices?
Academic research has long maintained that stock performance can largely be explained by several common characteristics such as size, value, price momentum, quality, and volatility. Factor indices are designed to capture the performance of these characteristics. These indices are intended to offer more focused exposures to factors than their market cap-weighted counterparts. A factor index sets out to capture factor exposures in a controlled and considered way. Single factor indices and factor combination indices, which can be tailored depending on the desired exposures, are common solutions used by investors.
4.4 What are thematic indices?
A thematic index is designed to follow a generally-accepted investment theme rather than a particular country, sector, or market segment. An example is an index comprised of companies listed in developed markets such as the UK and US that derive significant revenue from emerging markets. The purpose of this investment strategy would be to gain exposure to emerging markets without directly purchasing stocks issued by companies listed in emerging market countries, hence avoiding the country and currency risks and higher trading costs associated with some emerging markets investments.
5. Can I invest in an index?
An index is a hypothetical basket of stocks, so it cannot be invested in directly. But, there are thousands of investment products that track indices available through product providers and fund issuers including mutual funds, ETFs, and derivatives. Index-tracking investments are different from actively managed investments in that, rather than making active investment decisions in an attempt to outperform a particular market or market segment, they aim to closely mimic an index by holding the same securities at the same weight as the index.
Within index-tracking products, which are also referred to as “passively-managed,” the index provider calculates and publishes the index, and the product issuer licenses the rights to create the investment product based on the index. The product issuer manages the investment inflows and outflows, lists the product on an exchange (or otherwise makes it available for purchase), and markets/distributes the product.
6. Advisor’s guide to indexing and ETFs
The right ETF starts with the right index
All of your clients want positive outcomes. But each client has unique objectives—no two investors share the same goals, time horizon, and risk profile.
How can you improve outcomes for a wide segment of clients and gain a competitive advantage? A better understanding of indices and passive strategies can help.
Because indices are what powers Exchange Traded Funds (ETFs), and all indices are not created equally.
7. Financial literacy for children
At London Stock Exchange Group (LSEG), we believe financial literacy opens up options and opportunities. Whether it’s study and career choices now, or how to save and invest money later on in life, understanding how finance works can help build a better future for us all.
Help your children gain familiarity and achieve a practical understanding of how finance works with this set of educational materials on the role of the markets.
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