Know What You Own: Understanding Financial Indices

Learn to swim before jumping into the vast ocean of index products.

What is a financial index? And why do indices matter?

These are two critical questions for any ETF investor.

The best way to understand financial indices is to understand what they are not.

When we think about sophisticated investors, the typical Hollywood stereotypes come to mind: Depending on the type, they may be poring over financial statements; networking with their industry connections; or riding herd on a group of young analysts to pound the pavement and create market-leading research.

Whatever the methodology, their goal is simple: find the stocks that will outperform the rest of the market. This is considered classic, active management.

Despite the romance of this image, most studies—including ones from the Financial Analysts Journal, S&P, and Vanguard—suggest that these managers tend to fail. Despite the prestige and resources, most of these active managers fail to “beat the market” after accounting for fees.

Common sense explains why. Collectively, these managers are the market. Simple math tells you that, before costs, they must collectively tie the market for performance.

But all that suspender-wearing and research-making costs money. Moreover, trading stocks back and forth with one another costs money, too. So after costs, studies suggest that active management is a loser’s game.

As Vanguard founder and investing legend Jack Bogle says: in investing, you get what you don’t pay for.

Enter The Index

In response to this, starting in the late 1970s, a group of investors had a different idea: Rather than beating the market, why not simply match it at the lowest cost possible?

The way they did this was by tracking a financial index.

We are all aware of financial indices, because we hear them quoted on the telly or in the newspaper all the time. The FTSE 100, the CAC 40, the Barclays Capital Euro Aggregate Bond and the Dow Jones-UBS Commodity Index: All of these are indices designed to measure how well the market as a whole is performing.

There are two basic steps to creating an index:

Selection: Deciding which stocks or securities go in the index

Weighting: Deciding the relative weight of each stock in the index

All About Selection

Selection is the first and most important step: Out of all the stocks in the world, which ones should be included in the index?

The classic place to start is with “size.” The most popular indices that you hear about in the media, for instance, tend to focus on the largest stocks in a market.

For example, the FTSE 100 comprises the 100 largest companies listed on the London Stock Exchange. Similarly, the S&P 500 in the US holds 500 of the largest US companies. (There are small exceptions to these rules, which are explained in our article, “Advanced Index Selection Methodologies: Buffer Zones and Free Float.)

Other indices will focus only on the smallest stocks (so-called small-cap or small-companies indices), or stocks in the middle (midcaps or mid-sized indices).

But size isn’t the only option. Another class of indices selects stocks based on fundamental factors. For example, fundamental indices might only select stocks that pay dividends, those with low valuations or those that meet certain revenue criteria.

Indices also commonly select based on what sector a company comes from, or the country it belongs to. Development level (emerging vs. developed) is a popular screen as well.

Outside of equities, you see similar cutoffs: In bonds, for instance, most indices only focus on bonds that trade a lot (so-called liquidity cutoffs), or that use credit quality (i.e., only holding investment-grade bonds).

Indices and Coverage

Pick a fund

Weighting

Once you’ve selected which securities go into an index, the next step is to determine their relative size (weight) in the index.

The most popular methodology is “market-cap weighting.” Market-cap weighting assigns stock weights based on the size of companies: The larger the firm (based on its market capitalization), the larger its weight in the index.

Market-cap weighting is the best way to reflect the value of the market as a whole, but it is not the only way to craft an index. Other popular options include:

  • Equal-weighting: Assigning the same weight to every security
  • Dividend-weighting: Assigning the highest weight to the stocks paying the highest dividend
  • Fundamental-style weighting: Using factors like earnings or revenues to determine weights, rather than market capitalization
  • Volatility: Overweighting stocks with low volatility
  • Style weighting: Overweighting stocks that are at the extremes of valuation

In bonds, other factors apply, including weighting securities by the total value of debt they have issued, or placing higher or lower weights on securities with better or worse credit. (See our article, "Fixed-Income ETPs: The Basics" for more.)

In commodities, still other factors apply. (See our article, "Commodity ETPs: The Basics" or "Commodity Indices and Benchmarks" for more.)

Summary

Once you have selected and weighted an index, what remains is to maintain it. How often do you rebalance the index? How do you replace constituents when needed? Those structural nuances can mean the difference between an index that is easy for an ETF to track, or one that’s difficult.

All those decisions made, index providers then license their indices to ETF issuers, who run products that investors can access, making it easy to gain exposure to China … or the UK … or investment-grade bonds … all in one go.