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- A combination of mathematical and data-driven rules
- A set of systematic and dynamic rules
- A matter of size
A combination of mathematical and data-driven rule
A combination of mathematical and data-driven rules
Indexes measure the performance of a market and enable investors to better understand the collective movement of a group of stocks, bonds or other security types. Markets can be defined in many ways. For example, an index can represent the equity market of a country (e.g. the MSCI USA Index) or a region and a sector (e.g. the MSCI USA Healthcare Index). Indexes may target certain characteristics, such as ESG, that incorporates environmental, social and governance factors.
Indexes - dark blue
Indexes play an important role in financial markets. They help investors better measure performance, understand risk, and inform and guide the development of financial products.
Education 1:1
A calculation - not an opinion
The first documented index, the Dow Jones Transportation Average, was created in 1884 by Charles Dow and Edward Davis Jones. They created the “Customer’s Afternoon Letter,” a precursor to the Wall Street Journal, to provide unbiased reporting. It included a simple market average, based on 11 companies primarily from the railway sector, to help readers understand if the overall market was advancing or retreating.
Since then, the construction of indexes has evolved greatly, but basic principles of impartiality and transparency remain relevant today.
A tool to measure performance
Indexes are used by investors to measure market performance. Even those less involved in markets, will have heard in the news how the market is doing overall, if it’s up or down, or how certain countries or sectors are performing. Regardless of investment type (e.g. equities, fixed income, or other), you will find an index behind those measurements.
A point of reference
Investors cannot invest in an index. However, they may track or replicate an index in whole or in part, through investment vehicles, such as mutual funds, which are created and managed by investment managers. The investment manager, not the index provider, decides when to sell or buy the securities.
An essential role
There are broadly two main investment styles — active and passive (also referred as indexed). Indexes play an essential role in both.
In active management, an index is primarily used as a measurement of performance (whether the investment manager performed better or worse than the market). The investment manager’s process and philosophy determine the selection and weighting of securities.
In passive management, the goal is to mimic a market index, as opposed to outperforming it. The investment manager uses the index to inform the selection and weighting of securities. The portfolio will be influenced by how the index changes and evolves over time.
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What Are Indexes (05:58)
In this episode you will learn the basics about indexes: what they are, how they are constructed and why they are useful to investors.
Index Education systematic yet dynamic rules
A set of systematic yet dynamic rules
Index providers typically develop rules and methodologies that are systematic but also dynamic enough to keep pace with changing markets. They are usually publicly available and vary by index provider, but typically have some common steps:
Education 1:1 Duplicate 2
Step 1
Define what type of securities will be eligible for inclusion
Step 2
Decide how these securities will be represented in the index
Step 3
Determine the classification frameworks that may be used to help investors understand the composition and performance of the index
A matter of size
A matter of size
How an index is constructed depends on the type of security and its characteristics.
In equity markets, a common way is to use the value of a company’s shares, i.e., its market capitalization (calculated by multiplying the number of shares by the share price). It allows investors to assess its size based on its value: the higher the value, the bigger the company. As a result, companies with a larger market capitalization will have a greater weight when constructing a market-cap weighted index.
Similarly, in fixed income, a bond index can be constructed by considering the size (value) of the corporate bond. The larger the debt, the more weight an issuer will have in the index.
There are also some differences between equity and fixed income indexes:
1
Companies may continually issue new debt, and therefore more bonds may be associated with a company than share types.
2
Equities give shareholders ownership of a company for as long as that company exists, while bonds usually have a fixed lifespan.
3
Share prices are quoted in exchanges and therefore visible and accessible by the investor.
4
Bonds may often be over-the-counter (OTC) securities. Prices are agreed through the interaction of a buyer and a seller, so the settled price may not be easily visible to the outside world.
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Conclusion
Indexes play an important role in financial markets. They help investors better measure performance, understand risk, and inform and guide the development of financial products.
Learn with us - Index education
Learn with us
Explore more about indexes and the financial markets in our education series. From learning the basics through to exploring more at depth – here you will find everything index-related. Go back to the Index Education hub overview.
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