Your Index Matters

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.

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.

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.

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.

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).

Below is a hypothetical market cap-weighted index that includes five constituents.

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:

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.

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:

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. 

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.

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.

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. 

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.

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.

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.