An index is a measure of an economy or securities market, that encompasses the value or performance of several companies. For example, the DAX30 Index consists of 30 major German companies traded on the Frankfurt exchange.
Most indices use market capitalization weighting, meaning that the more share value a stock has, the more weight it is given in the calculation of the overall index.
For instance, if a company’s market capitalization is $1m and the market capitalization of all stocks in the index is $100m, then this particular company would contribute 1% to the total index.
WHAT DOES AN INDEX DO?
The logic behind indexing is simple: representation. Markets or even individual market sectors (such as pharmaceutical companies, or technology companies) can be enormous, including hundreds and even thousands of securities. For most market participants, buying up all these securities just to access one market or trend is too expensive and time-consuming—not to mention ineffective, as that approach inevitably would include securities with negligible influence on the portfolio.
That’s where indices come in. An index is comprised of only the securities most relevant to its investment theme, allowing market participants to follow market trends without having to track the entire available universe of securities. Essentially, an index acts as a yardstick, capturing representative exposure to a particular market or sector.
There are thousands of available indices on countless market themes or approaches.
Chances are if you can imagine it, there’s an index for it.
WHO USES AN INDEX?
Market participants can use indices in a variety of ways:
- To assess a given market’s performance.
- To gauge how well an active strategy is working.
- To serve as the foundation for investment products, such as ETFs or mutual funds.
- To evaluate a market’s risk profile or its diversification benefits.
- To measure passive risk premia.
THE EVOLUTION OF INDEXING
Indices have been around since 1884 when Charles Dow (the founder of Dow Jones & Company and the Wall Street Journal) cobbled together an 11-stock transportation tracker focused mostly on railroads. This index would later become the Dow Jones Transportation Index.
The original function of indices was to act as a barometer of the stock markets, offering observers a concrete measure of investor appetite or potential IPO prospects. They still do this, to some extent.
By the 1920s, however, indices had evolved from barometers into benchmarks meant to gauge market performance. In the 1960s, designed with the Capital Asset Pricing Model (CAPM) and cap-weighting structure in mind, indices began to be used to describe the baseline market, to which the results of active investment managers could be compared.
The earliest index-tracking funds emerged in the US in the early 1970s and were initially adopted by institutional investors. Vanguard launched the first retail index tracker in 1976.
Today more than $5 trillion is invested in index funds, and assets are growing every year. The advantages are obvious: Index-tracking products like ETFs or mutual funds make it simple and easy for investors to enact asset allocation strategies or fine-tune portfolio diversification.
And the next generation of index funds offers even more advanced attributes, including indices that aim to incorporate low-volatility or momentum strategies, or alternatively weighted (or so-called “smart beta”) indices that eschew market cap weighting altogether.