Basics of indexing

What is an index?

An index is a collection of securities intended to represent a given market or market segment. Each holding within an index is known as a constituent.

It is important to bear in mind that an index is a theoretical concept.

An index can be as broad as the US stock market (the S&P 500 has around 500 constituents) or as narrow as a single country or industry (the iShares China Large Cap UCITS ETF USD (Dist) fund has less than 30 constituents).

Indices can be designed to target different styles, sizes, sectors, target maturities or geographic locations.

 


How indices differ

An investor looking for exposure to a particular market or market sector could have more than a dozen indices to choose from.

Each index has its own methodology (or set of rules as to what is included in that index) established by the index provider.

Common methodologies in equity indices include: number of constituents, capitalisation, style and sector composition.

 


Index-tracking vs. active investment

Most ETFs are index-tracking funds. This means that they aim to replicate the performance of a specific market. Index-tracking is different to active investment, where a fund manager looks to outperform the market.

Index-tracking funds tend to have lower costs than actively-managed funds as their goal is solely to match the performance of the index. Active funds charge higher costs for the possibility, but not the certainty, of outperforming their benchmark. After these fees are taken into consideration, active funds are very often unable to outperform their benchmark.

Both investment approaches have their advantages. In many cases, some form of blending the two approaches works best.