[This article comes from the learn section on our site.]
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 relying 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.
This article continues...