What is an index, really?Needs one idea

A rule for picking things and a rule for weighting them, published by a company, revised on a schedule. Not a measurement of a market.

3 min read · 522 words

A published rulebook with a number attached. Somebody decides what goes in, how much of each, and when that changes — and then computes a number from those decisions. The number is a consequence of the rules, not a fact about the world.

The three rules that decide everything

• What is eligible. Which country, which exchange, which size, whether a company with two share classes counts once or twice, whether it must be profitable. Every one of these is a choice.
• How much of each. By market value is the common answer: a company worth twice as much gets twice the weight. But equal weighting, price weighting and value weighting all exist and give different numbers from the same companies.
• When it changes. Quarterly, annually, or on an event. The date is published, which means everybody knows when the index-tracking money has to trade.

Why the weighting is not a detail

In a market-value-weighted index, a company's weight rises as its price rises. The index therefore holds more of what has already gone up and less of what has not — automatically, without anybody choosing it. That is a defensible design and it is a design.

A price-weighted index does something stranger: a share priced at 300 has three times the influence of one priced at 100, regardless of the size of either company. A share split changes nothing about a business and changes its weight in such an index immediately.

An equal-weighted version of the same list has to sell what rose and buy what fell at each rebalance to stay equal. Same companies, opposite behaviour, different return.

Price return, total return, net return

Three versions of the same index, and comparisons go wrong here more often than anywhere else:

• Price return ignores dividends. It is the number quoted in the news.
• Total return reinvests dividends gross.
• Net return reinvests them after an assumed withholding tax.

A fund that pays and reinvests real dividends is measured against one of the three, and against the other two it will look like it is doing something it is not. That is most of the answer to why a fund's return differs from the index.

Who publishes it, and why that matters

Index providers are companies. They license the rules, and a fund that tracks an index pays for the right to name it. The rulebook is public; the judgement calls inside it — a committee deciding whether a country is "developed" — are real decisions with real consequences for money that follows the rules.

None of that makes an index unreliable. It makes it a product rather than a thermometer, and reading the methodology tells you what you are actually buying when you buy a tracker of it.

What to look up before comparing anything to an index

• Which version — price, total or net?
• What currency, and is it hedged?
• How many constituents, and how concentrated are the largest few?
• When does it rebalance, and does the fund you hold rebalance on the same day?

The ETF and fund pages cover the wrapper; this page is about the thing being wrapped.