Market Indexes and Index Investing

An index is designed to represent and measure the performance of a specific market, asset class, sector, or investment strategy. The S&P/ASX 200 Index, for example, tracks 200 of the largest stocks by market capitalization listed on the Australian Stock Exchange. Unlike individual securities, market indexes aren’t directly investable. Instead, most investors use index funds or ETFs, which are designed to track the performance of designated indexes, less fees.

The role of an index

Indexes are used in both index and active investing.

  • Index investing: This includes mutual funds and exchange traded funds (ETFs) that seek to track the performance of a specified index. These “index” funds provide simple, low-cost ways to gain exposure to the market.
  • Active investing: Indexes are typically used to measure performance of active funds. Alpha-seeking managers attempt to “beat the market” by outperforming their benchmark—which is usually an index.

Indexes come in all shapes and sizes

Indexing began in equities but has grown to encompass much more. There are millions of indexes spanning all major asset classes, including fixed income, currencies, commodities and real estate (Figure 1).

Indexes can be broad—like the MSCI World, which focuses on global developed market equities—or track narrower segments of the market, including single countries, specific sectors (e.g., technology), or themes (e.g., clean energy).

Figure 1

Equity Fixed Income Currency Commodity Real Estate
S&P/ASX 200 Index Bloomberg AusBond Composite Index ICE U.S. Dollar Index S&P GSCI Crude Oil Index S&P/ASX 300 A-REIT Total Return Index
NASDAQ-100 Index Solactive Australian Investment Grade Corporate Bond Select Index ICE Euro FX Index Bloomberg Sugar Subindex Dow Jones U.S. Real Estate Index
MSCI World Minimum Volatility (AUD) Index S&P/ASX Bank Bill Index S&P Chinese Renminbi Index Bloomberg Precious Metals Subindex MSCI China Real Estate 10/50 Index
ROBO Global Robotics and Automation Index Markit iBoxx Global Developed Markets Liquid High Yield Index S&P Indian Rupee Index UBS Bloomberg CMCI Livestock Index Total Return Benchmark Industrial Real Estate SCTR Index

The above table is for illustration purposes only. It serves as a general overview and is not exhaustive.

Index providers create and maintain indexes

Index providers, like MSCI and S&P Dow Jones Indices, are responsible for constructing and monitoring a wide variety of indexes.

Each provider uses a unique, rules-based methodology to build their indexes. This methodology is used to define the scope of the index, such as which securities or financial instruments are included and their respective weightings.

Index providers monitor not just the market but also regulatory and corporate events for ongoing index maintenance. For example, providers may need to rebalance the index—or adjust the weighting of constituent securities—based on corporate actions (e.g., stock splits) or changing market conditions.

The composition of indexes changes frequently

During periodic reviews, index providers may make changes to their indexes. For example, a provider will remove securities that no longer meet the criteria for index inclusion as outlined in its construction methodology.

Alternatively, an index provider may add a security if it becomes eligible for inclusion (e.g., if a private company takes its shares public). Index providers also contend with macroeconomic events, like geopolitical tensions that result in country-wide or firm-specific sanctions, and adjust their indexes accordingly.

For example, in July 2019, U.S. sanctions on Venezuela sparked liquidity concerns around Venezuelan bonds. As a result, JP Morgan reduced the weight of Venezuela’s sovereign bonds to zero in its debt indexes.

Fund managers manage funds, not indexes

Index fund managers often engage with multiple index providers. The top index providers for Australian listed index ETFs are shown below (Figure 2).

Index providers license their indexes to asset managers and other financial institutions for a variety of uses, including benchmarking investments.

Index fund managers outline their investment objectives and determine which index benchmarks will best align with those objectives—and, ultimately, the needs of investors.

Figure 2

Australian Listed ETFs
Provider Assets (Australian A$ millions) Market Share
Standard & Poor's 25,914 40.66%
MSCI 7,803 12.24%
Bloomberg Indices 5,175 8.12%
FTSE 4,575 7.18%
Solactive (Structured Solutions) 4,515 7.08%

Source: Bloomberg, ASX as at May 2020

Managers of index mutual funds and ETFs strive to track the performance of a fund’s underlying index as closely as possible. This can be achieved in two ways:

  1. Full replication. A fund may exactly match the composition of the index by holding every security at the same weight as the index.
  2. Owning a subset of the index: stratified sampling In some instances, such as funds that transact in less liquid fixed income markets, it may be difficult or impossible to purchase every index component. (In fact, some bond indexes have thousands of securities.) Instead, portfolio managers may seek to deliver index-like risk and return characteristics by holding and managing a representative sample of index securities (Figure 3).
Example of Sampling

There’s nothing ‘passive’ about index fund management

Some people think that index funds are managed by computers. In reality, a lot of work gets done behind the scenes by skilled portfolio managers.

For example, during index rebalances and reconstitutions — reweighting and deleting or adding securities, respectively — index fund managers must rebalance or reconstitute their portfolios accordingly.

While indexes assume an immediate, frictionless, and costless implementation of changes, index fund managers are faced with transaction costs, risks, and other frictions when they execute trades in their portfolios.

At the same time, when trading around index events, index fund managers have control and exercise discretion in seeking to track the index and maximize shareholder value.

This means that index fund managers must review information about upcoming index changes and have an implementation plan in place to buy or sell securities to align their portfolio with the index in a way that balances risk, return, and cost.

Other responsibilities may include tracking corporate actions that can impact the composition of an index, reinvesting dividend or interest payments received from a fund’s portfolio holdings, and monitoring risk in their portfolios and in the market.

In instances where a portfolio holds a sample of an index’s securities, portfolio managers have discretion over security selection and can choose which securities to add or remove from the portfolio in order to continue tracking the index while aiming to minimize transaction costs.

Two distinct roles of equal importance

While index providers and index fund managers play different roles, they are equally important to the index investing landscape.

Index funds provide a way for investors to build diversified portfolios in a cost-efficient manner. This would not be possible without the efforts of index providers to build and maintain the index methodologies that underlie these funds.

As index investing continues to grow, it will be important for investors to understand the crucial, yet distinct, roles that these market participants play.