Generally speaking, an index is an indicator or measure of something. In simple terms, in the world of investing, an index is a hypothetical portfolio of securities designed to represent an asset class, market, or market segment.
How indexes are used
Indexes play an important and informative role at every step of the investment process. Economists use them to analyze economic trends, and investors make decisions based on economists’ forecasts. Institutional investors use indexes to conduct risk analysis, develop investment policies, and create asset allocation strategies. Nearly all types of investors use them to evaluate the performance of their investment portfolios. Indexes are also used as a basis for investable products such as mutual funds or ETFs that allow for passive investment in a specific market, market segment, or asset class.
How index constituents are chosen
To deliver an unbiased, complete view of a given market, the method by which an index’s constituents are selected must be free of subjectivity, as the index should include all of the practical opportunities available in the market. An objective, rules-based formula for determining which companies become components of the index (as opposed to a hand-selected sample) is a critical component of the construction methodology of a truly representative index.
For example, if an index designed to represent the large cap segment of a given market omits some of the large cap companies readily available to market participants, and that index is being used to define the basket of stocks from which an investment manager may select, the resulting large cap portfolio could be left without exposure to important drivers of the large cap market.