Indexes 101

What is an index?

• A financial index measures the performance of a list of instruments (bonds, stocks, etc.) that are selected and weighted according to an employed methodology that describes a set of rules governing the construction of the index.

• IIA defines an index “as a number calculated by reference to a theoretical collection of assets, market indicators, securities or derivatives whose absolute level or periodic difference relate to the performance of the theoretical collection over that period.”

• When commentators talk about “the market,” they often mean an index that measures the performance of a market.

• A financial index helps investors access markets and boil down financial market data into understandable and usable information.

• Indexes measure the performance of representative securities within a particular market, sector, industry strategy or objective. Indexes are calculated, maintained and administered according to published rules in a formal methodology.

What is the difference between an index and an index-based product?

• Indexes are sometimes confused with the funds that may use them. They are not the same thing. Indices themselves are not investible products. For institutions and individuals to gain exposure to an index or the return of an index, one must invest in an investment vehicle such as a mutual fund or ETF that mirrors that index.

• Regulated financial institutions and advisers use indexes in a variety of ways including to benchmark their investment performance, allocate assets and to create investment products such as mutual funds and ETFs.

• As independent index providers, IIA members do not trade the underlying component securities of their benchmarks nor do they directly create products for investor use. This model mitigates the real and perceived conflicts of interests by entities that do not separate these key functions, such as investment advisors who create proprietary benchmarks.

Who are the market participants and decision makers on each stage of the investment process?

• Market Price Makers

o Market makers and traders create liquidity and facilitate trading of financial instruments to determine the market-clearing prices for financial instruments.

• Data Providers & Exchanges

o Pricing and trade data sources are used by index administrators to value the underlying constituents of an index. The most transparent sources for constituent prices are regulated securities or commodity exchanges and transaction facilities.

• Index Administrators

o Index administrators create, maintain, and govern the calculation and maintenance of an index and its methodology.

• Asset Managers, Banks and Product Issuers

o Indices themselves are not investible products. Asset managers create the investment vehicles and investible products, such as mutual funds or ETFs, to mirror a desired index.

Indices are used as benchmarks to evaluate the performance of an active manager’s portfolio.

• Investors

o Investors ultimately purchase, sell, and trade investment products whether they are index based or actively managed. Investors or their financial advisors determine the appropriateness of the products that meet their investment objectives. Independent index providers do not determine whether any index-based investment product is appropriate for investor use. Index providers administer indices, but investors working with consultants, boards of trustees, financial advisors and asset managers determine the indices and/or index products they use.

What are the benefits of independent indices and index products?

Indices have pushed fees for all products down, increased overall market transparency and prompted greater innovation.

• Integrity. Indices from independent index providers, who neither trade the underlying component securities nor directly create investment products, allow investors the most protection from conflicts of interest, best practices in governance, accountability, and benchmark quality.

o IIA membership is open to independent index businesses, who must comply with the IIA Best Practice Guidelines, IOSCO’s Principles for Financial Benchmarks, and local regulations.

• Low costs. Index-based products have led to lower costs for all products, regardless of management style or market environment, due to increased innovation and competition. Estimates for the direct effects of indexing save investors approximately $15 to $30 billion per year. The indirect benefits, such as the competitive pressure forcing active managers to decrease fees, are estimated between $40 and $50 billion

• Transparency. Indexes are causing all managers—active and passive—to run their portfolios with increased transparency. Index providers disclose their rules-based methodologies, including the eligibility rules that determine the constituents of an index. These disclosures help investors by providing the transparency they need to understand investment-based products.

• Access (democratizing finance) and consumer protection. Indexed products enable all investors to capture exposure to previously inaccessible asset classes, such as commodities, foreign exchange rates, credit and emerging market securities, and fixed-income strategies. These asset classes have typically only been available in over the counter markets but are now accessible through ETFs that provide investors with the consumer protections of exchange-traded markets.

• Innovation. Indices have been created to track all asset classes and to bring quantitative strategies to all investors. Indices tracking these asset classes can be packaged in products like Exchange Traded Funds (ETFs) and traded via an exchange. They may be used in active funds to trade various strategies efficiently. Indexed sector funds are an example.

o Index products enable more efficient transfer of risk between investors.

o All investors have benefitted from the tighter bid/ask spreads market-makers have helped create, regardless of whether investors are trading the underlying component securities, the ETFs, or options and futures.

Who should be responsible for filtering which issuers are eligible to be included in an index?

• OFAC and securities exchanges based on their listing standards take this responsibility in the United States. If a company is eligible for listing in the US or its shares are eligible for purchase by US citizens, then it should be indexable.

Should index creators determine whether to include certain eligible issuers based on factors like governance or related issues?

• Determining whether a company, foreign or domestic, has poor governance or accounting practices requires legal (objective) or merit-based (subjective) assessments of the company’s policies and practices.

o Legal conclusions should be made by the courts and legislators.

o Merit-based conclusions should be made by the investors or managers that will buy or sell the company’s shares. If the company’s shares are legally available for purchase and meets the criteria for a particular index, then it will be included in the index. However, the index is not an investible product. When investment managers buy and sell equity to create a portfolio, they have a fiduciary obligation to make merit-based determinations about the appropriateness of specific companies and are free to deviate from a given index.

• Furthermore, it is difficult to determine when a company should not be eligible for inclusion in an index and still be eligible for individual or institutional investors to acquire directly. Such distinctions could lead to inequitable outcomes.

How should Emerging Market issuers be evaluated and by whom?

• Legal conclusions should be made by the courts and legislators. Merit-based conclusions should be made by the investors or managers that will buy or sell the company’s shares. OFAC and securities exchanges should apply their standards.

• Evaluating the quality of a given regulatory framework, including audit quality and accounting standards, requires merit-based assessments. Index providers do not evaluate the merits of US or foreign regulatory frameworks. Where more rigorous protections exist in foreign jurisdictions, index providers do not exclude US companies for failure to meet those heightened requirements. The inverse is also true where the US has more rigorous requirements than foreign counterparts. When investors make such merit judgments, they can create indices tailored to their investment needs.

• Investment advisors can trust that the companies in a given index have met the requirements for listing on their respective exchanges in accordance with the laws of those jurisdictions.

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