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An Investor’s Guide to Indices

Chapter 1

Defining an Index

WHETHER YOU’RE LOOKING TO TRACK A MARKET’S PERFORMANCE, EVALUATE YOUR PORTFOLIO, OR INVEST IN INDEX-LINKED INVESTMENT PRODUCTS, INDICES ARE INDISPENSABLE FINANCIAL TOOLS.

INDICES CAN SERVE AS:

  • Economic indicators
  • Performance benchmarks
  • The basis for index-linked investment products
  • Tools for research & analysis

Indices are all around

IS THE STOCK MARKET HEALTHY? WHAT’S HAPPENING IN THE BOND MARKET? ARE COMMODITY PRICES GOING UP?

The answers to all of these questions involve indices — that’s because they are designed to measure market performance. It’s probably fair to say that the closing level of the Dow Jones Industrial Average® gives you a sense not only of what happens on any given day in the U.S. stock market, but also where the U.S. economy stands at any given moment.

In fact, indices can have an impact on your financial life in many ways. The changing value of the S&P 500® can determine the interest you earn on your market-linked certificate of deposit (CD) or the capital gains you realize on a U.S. equity exchange traded fund (ETF). Government indices determine how much is withheld from paychecks for Social Security and how much the variable-rate on a mortgage loan will change.

Given the practical impact of indices, it is important to know what they are and how they work:

But what exactly is an index?

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Market Indicators

NO INFORMATION, EXCEPT MAYBE THE WEATHER, IS MORE WIDELY REPORTED THAN THE CURRENT LEVELS OF THE DOW® AND THE S&P 500. AND THERE’S A REASON THAT PEOPLE PAY ATTENTION.

Indices provide both real-time information about the health of financial markets and a regularly updated snapshot of market direction.

When equity indices are rising, it’s because investors are buying more shares of the indices’ component stocks than they’re selling, and their prices are going up. The opposite is occurring when index levels are declining.

The Dow Is Up 200 Points: Good or Great Day?

When investors and the media talk about market performance, they typically cite the number of points an index gained or lost. But the actual impact of these numbers is based on the prior index level.

Use the tool below to see how the percentage change differs depending on the starting index level.

  • 7,000
  • 9,000
  • 11,000
  • 13,000
  • 15,000
  • 17,000
  • 19,000
  • 21,000
  • -800
  • -600
  • -400
  • -200
  • 0
  • +200
  • +400
  • +600
  • +800

0%

Benchmarks

INDICES ENABLE INVESTORS TO EVALUATE THE PERFORMANCE OF SECURITIES, ACTIVELY MANAGED FUNDS, AND INVESTMENT PORTFOLIOS RELATIVE TO THE MARKET.

In this way, indices act as yardsticks or benchmark measures. For example, large institutional investors, financial advisors, and individual investors alike benchmark their investments to indices to determine whether they are outperforming or underperforming the markets in which they invest.

Indices are used by financial professionals to benchmark the portfolios they manage against market performance. Even individual investors can evaluate how their investments are performing relative to the market using indices as a reliable reference point.

To make a meaningful comparison between an investment portfolio and an index, it is crucial to use the right benchmark. It would be misleading to compare the results of a mutual fund that invests primarily in mid-sized companies to those of an index tracking large- or small-sized companies.

This need to compare apples to apples is one reason there are millions of indices. Each index measures a specific market, market segment, or investment strategy in which investors, whether individual or institutional, might choose to invest.

Index-based Investment Products

THE NUMBER OF INDICES CONTINUES TO GROW BECAUSE THERE IS GROWING APPETITE FOR NEW WAYS TO INVEST IN THE CAPITAL MARKETS USING INDEX-LINKED PRODUCTS, SUCH AS ETFS.

Knowing the difference between an index and an index-linked product is crucial for understanding the nature and role of both indices and the investment products that track them.

Research & Analysis

BECAUSE INDICES ARE STABLE AND PUBLICLY RECOGNIZED MEASURES, THEY ARE WHERE ANALYSTS AND MARKET PARTICIPANTS COME TOGETHER TO EVALUATE TRENDS, DEBATE CONSENSUS, AND PUBLISH PROPRIETARY INVESTMENT STRATEGIES.

All walks of market professionals use index data as the basis for evaluating market behavior and trends. Financial analysts might use index data for company or sector attribution to determine what is driving individual stock prices and to make buy/sell recommendations.

An analyst at a hedge fund may use real-time data to identify quantitative signals that have historically represented buy or sell opportunities.

An index tracking healthcare costs or jobs might even inform a government official’s views on policy.

Indices help financial professionals and investors speak the same financial language.

A spectrum of indices

There is an index for nearly every corner of the market. Indices typically fit into one of a few broad categories that can be segmented and even cross-segmented into much narrower niches.

Roll over to explore:

The wide availability of market indices has contributed to the proliferation of passive investment products. Originally, passive investing meant purchasing shares in an index fund linked to the U.S. market. But now it’s possible to invest in a variety of index-linked products across multiple asset classes and investment strategies.

CONGRATULATIONS

You've completed chapter 1. Now, test your knowledge by taking a brief quiz.

Take the quiz

Select the best response to each question and click "Submit" to view your results.

    • Equities
    • Commodities
    • Fixed income
    • All of the above
    • The change in the index level points, e.g. from 12,245 to 11,568
    • The percentage change between index levels
    • Neither
    • Broad market indices
    • Sector indices
    • Strategy indices
    • Dividend indices
    • Indices
    • Index-linked funds
    • Futures and options
    • None of the above
    • All of the securities in the index can be bought and sold easily in the market
    • The index is composed of environmentally conscious securities
    • Only stocks from developed markets are eligible to be included
    • None of the above
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