An index is a group of securities representing a certain market, asset class, or basket of securities represented by a single valuation or metric – the index level. Each index has a daily value based on the underlying securities it tracks, which can be constructed according to a number of different methodologies. For example, capitalization-weighted, price-weighted etc. Indexes can act like a thermometer, gauging a market’s performance over time such as indicating whether a market is in a bullish (high) uptrend, a bearish (low) downtrend, or stagnant (not trending in any direction).

Methodology Behind an Index

Index construction methodologies and rules will decide which securities are included from a given market. To create an emerging market index, for example, the provider must first establish which countries are designated as developing markets, and then which firms from those countries should be included.

In this way, indexes act as a recipe for passive ETFs - showing what ingredients are needed and how much to add. The objective of a passive ETF is to mirror the holdings of its designated index. The most well-known passive index in North America is probably the S&P 500 - it tracks the performance of the 500 largest U.S. companies by market capitalization. If you want to invest in American stocks, but don’t want to pick favorites, then ETFs which track the S&P 500 provide a way to buy the largest companies driving the U.S. equity market in one go.

Examples of Indexes:

• S&P 500
• S&P/TSX Composite
• FTSE 100
• MSCI Emerging Markets
• Nasdaq 100
• Euro Stoxx 50

*This article was written in collaboration with Trackinsight.