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What is an index?

An index is a group of securities chosen to track a particular investment theme such as a market, asset class, sector, industry, or even strategy. Generally the goal is to accurately represent the risk/return profile of that theme without necessarily holding every security that might qualify.

The exact compilation of securities in an index is known as its basket, while the proportion of the index each individual security comprises is its weighting. An index’s value is a single number that, when referenced to a starting value, describes how the index has performed over time.

For example: The FTSE 100 is an index designed to track large-cap stocks; its basket includes the stocks of the hundred largest companies on the London Stock Exchange, weighted by market cap. On August 9, 2013, its value was 6574.34.

Simple enough, right?

What does an index do?

The logic behind indexing is simple: representation. Markets or even individual market sectors (such as large cap stocks, 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 indexes 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 indexes tracking countless market themes or approaches, from large cap global stocks to North American office REITs to Chinese currency markets. Chances are, if you can imagine it, there’s an index for it.

Who uses indexes?

Market participants can use indexes 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

Indexes 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 indexes 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, indexes 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, indexes 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 offer even more advanced attributes, including indexes that aim to incorporate low-volatility or momentum strategies, or alternatively weighted (or so-called “smart beta”) indexes that eschew market cap weighting altogether.