What is an index?

An index is not an investment product

An index is a calculated figure that describes how a market performs. You can't buy it directly. The S&P 500 is a list of the largest US companies and their weights; an ETF is a fund that buys the same companies at the same weights.

That's why two ETFs from different issuers can track exactly the same index, and the difference between them comes from costs, structure and tracking accuracy, not from the contents.

Who makes the index, and by what rules

Indices are maintained by an index provider, such as S&P Dow Jones Indices, MSCI or FTSE Russell. Every index has public rules: which companies qualify (market, size, trading volume), how they are weighted and how often the list is updated.

The rules decide what you actually own. "World" can mean only developed markets (MSCI World) or emerging markets as well (MSCI ACWI). The name doesn't tell you everything. The rules do.

Market-cap weighting

Most broad indices are market-cap weighted: the bigger the company, the bigger its weight in the index. When a company's value rises, its share grows automatically, without anyone having to buy more.

This has consequences. When a few large companies grow a lot, the index becomes more concentrated than its name suggests. In the S&P 500, for example, the ten largest companies have made up a considerable part of the whole index in recent years.

Rebalancing and the total return index

An index is updated regularly, for example every quarter. Companies are then added and removed, and the weights are adjusted to match the rules. The ETF makes the same changes in its own portfolio.

A price index measures only the change in share prices.

A total return index assumes dividends are reinvested. Over the long term the difference is large, so when comparing returns, check which one you're looking at.

An index is also a point of comparison

An index is used as a benchmark: it's what you measure an active fund or your own portfolio against to see whether it succeeded. The comparison is only fair if the index matches what the portfolio contains.

Next: now that you know what an index is, choose what you want to track. Broad equity ETFs: S&P 500 or the world? →

This content is for information purposes only and should not be construed as investment advice or a recommendation. Investing always involves the risk of losing capital. The value of financial instruments and investments can go up or down, and past performance is no guarantee of future returns.