For many market commentators, identifying the difference between market indexes and investment products too often proves more difficult than it should be.
One of the most valuable and useful tools for market participants, indexes are frequently misportrayed, misunderstood, or misperceived by the very investors who can most benefit from them. In the process, market participants can lose sight of the value indexes deliver. This represents a fundamental issue for today’s investment markets, and indeed for the membership at IIA. Many market participants don’t understand the differences, or that there even is a difference, between indexes and the investment products and strategies based on them.
To clarify, let’s highlight a few key issues:
Indexes are Not Investment Products
I can’t tell you how many times someone has told me they are “investing in an index.” The reality is that an index is merely a vehicle to track a certain basket of securities; you are not able to invest directly in an index.
Investors can invest in products based on an index, such as mutual funds or exchange-traded funds, and these products are offered by an investment provider such as an asset manager, not an independent index provider. Investors should understand their index-based investment dollars are in an investment product not, the underlying index. Investors decide when and how to invest in index products to execute their own investment vision, but the indexes don’t do that thinking for investors.
Indexes are Managed Based on Rules
Indexes are based on a methodology or set of rules governing what securities they represent. These rules can be based on a variety of criteria such as size, geography, sector, sustainability, or even style such as growth or value.
The bottom line is that these are set rules and are not changed based on market fundamentals or an active market bet; they are rules-based decisions. Some investors think of an index-based investment as a “set it and forget it” scenario, akin to an algorithm preset to make decisions based on certain criteria, just as one might passively refresh household supplies from Amazon once a month, or Netflix queues up your next show. Index methodologies can of course be adjusted over time, but typically these adjustments are done in a gradual fashion with industry input and consultation with any changes to methodology publicly disclosed.
Indexes Reflect Markets
In recent years, media commentators and even politicians have begun to portray index providers as market “standard setters”, but this is a misunderstanding. The reality is that indexes reflect existing market standards, such as exchange listing requirements and regulatory rules for the companies they track. It is not the index provider’s role to set market policy or to determine which companies are suitable for investors. The index providers’ role is to provide benchmarks that best reflect the markets they are measuring. Regulators and exchanges determine listing standards and suitability is a decision between investors and their financial advisors.
Why are These Distinctions Important?
While index providers play a critical role in the effective functioning of the global investment markets, market participants’ misperceptions have attributed certain characteristics of investment products onto the index providers. Independent indexes are meant to reflect market action and not determine the markets. By working closely with market participants such as investors and regulators, while remaining independent and objective, index providers can provide the basis for investments with integrity, transparency and very low relative cost.
As index-based investing has grown in recent decades, individual investors have benefitted from increased transparency and access to the investment markets indexes provide. Because independent index providers are separate entities, independent from the investment provider, there is additional protection for the investor because one set of eyes is managing the index and another set of eyes is managing the investment based on the index.
Education and transparency are extremely important so that market participants understand the specific and valuable role that indexes play in the market ecosystem. They should know where the role of an index provider ends and product providers’ roles begin. As an industry, we must help market participants understand the roles index providers and product providers with respect to market indexes and portray them for the very useful role they play in the market ecosystem.
Resisting the temptation to equate apples with oranges when it comes to market indexes and the investment products based on them will help alleviate confusion and, in the meantime, make us all better investors, too.