What Is An Index, Anyway?

The other day, as I realized it had been way too long since I’d left the house, I started to remember smiling my way through dinner parties in the “before times.” In fact, when I shut my eyes, I could see myself sitting at a full table, a delicious bowl of hot soup waiting for me to dive in. Unfortunately, I’d just heard a common question from the person sitting next to me: “So, what is an index, anyway?” While I do hear this question a lot, I don’t like to discourage people from asking because first of all, not everyone cares about this important tool for investors, and second, those who do care often have the wrong idea about them. So, if you’ll kindly pass the salt, I’ll try and explain.

An index is not an index fund or vice-versa

First, let me get some distinctions out there that are important to understand. Now, MSCI as well as other independent index providers do not create or manage index funds. We build indexes. As I’ll explain a bit later, their main function is to measure markets, and managers use them in variety of ways throughout the investment process. For example, managers select many of these indexes as the basis for their index-tracking funds; these funds are what many people refer to as “passive investments.” It is important to know that while managers use indexes to create regulated financial products, no one can invest in an index and independent index providers, like MSCI, do not offer investment products or advice. You can’t invest in an index.

So, if an index isn’t an investment, what is it? I’m glad you asked. At its core, an effective index must contain three essential elements to be useful for investors. First, it must be transparent, meaning that the index must be based on widely available information and verifiable by a third party. Second, it must be investable, meaning someone could actually invest in the securities referenced in the index. Finally, it must be systematic, meaning that the construction of the index must be determined by objective rules and not be dependent on human judgment.

The history of indexes is a history of innovation

While the variety of indexes has expanded and the ways in which investors put them to work has changed, an index remains a descriptor, a useful measure of markets. At the highest level, an index may seek to cover a defined market, say, global equities measured by the MSCI ACWI Investable Markets Index. A broad market index like this also can be broken out in various ways, such as by region or company size, for example. Managers, whether active or passive, carefully select the index that makes sense for them and use it as a yardstick to measure performance of their portfolio, and communicate that performance to clients.

But wait. There’s more. After living a bit with indexes used as a benchmark for traditional slices of the market, people started to realize the utility of getting more granular. Fortunately, advances in technology arrived in time to help drive this forward, which allowed for all kinds of innovation.

Today, there are indexes that seek to define a market by referencing securities within an objectively measured market defined by an investment style. For example, there are indexes based on factors such as value, growth or momentum, as well as those that include environmental, social and governance (ESG) criteria, climate-related considerations and thematic methodologies, which involve long-term trends that may have far-reaching effects on the market. Think about self-driving cars and advances in genomics. What’s more, investment firms have been able to build upon index-tracking funds, adding financial products like index-linked exchange-traded funds (ETFs) to their product lines, which can provide efficient, easier-to-use ways for investors of all stripes to participate in the stock market.

What’s next?

In my next column, we’ll continue the conversation with a look at what many see as the next logical step for indexes, the next innovation offered by managers using indexes. It’s something called direct investing, where investors look to own a subset of securities in a given index that their managers personalize to their preferences, rather than an index fund.

But more on that next time. Right now, my soup is getting cold.