At The CM Group we are frequently asked what an index is and how does it work? For this weeks blog post we are going to do a refresher on this topic.
First we have to define what an index is. An index is a method used to track the performance of a group of assets in a standardized way, it is a basket of securities intended to replicate a certain area of a market. A common type of index is broad based and is used to capture the entire market, a good example of this would be the S&P 500 index. There could also be more specialized subindices that track a particular industry, for example, in Calgary people will talk about the energy market or the energy index.
Things can get complicated when we talk about an index versus a benchmark, because sometimes the benchmark can be an index but, it can also be a custom derived measure. For example, a custom benchmark might consist of 50% of the S&P 500 Index for stocks and 50% of the US Aggregate Bond Index or the Canadian TMX Bond Index for fixed income. Indices in financial markets are often used as benchmarks- this is important to note- because when we hear talk about performance it is usually in reference to how it is compared to the benchmark. This can be cause for confusion and sometimes people with say their portfolio has underperformed the S&P 500, but that person's portfolio could actually be 50% invested in bonds, yet they are comparing it to a benchmark that is 100% US stocks.
Interestingly enough, you cannot invest directly in an index. When people refer to index investing, they are actually talking about investing in exchange traded funds or mutual funds that are created to replicate a certain index, whether that be a market index like the S&P 500 or a subindices like the energy market or even a bond market index ETF. When putting together these mutual funds and exchange traded funds, fund sponsors attempt to create portfolios that are mirroring the components of a certain index. This is an important point, because you cannot measure yourself against an index unless you own all of the same things that are in the index.
The key takeaway here is that an index is a measure of price performance of a basket of securities using a standardized metric and methodology. And, when looking at things like performance, it is important that the benchmark properly reflect the asset allocation of the portfolio.
To learn more about indexes, including what the major indexes in Canada, the US and international and emerging markets are tune in to the latest episode of the Free Lunch Podcast “Indices, you must reconstitutes” available across all listening platforms.
Stay happy, stay safe, stay well!
The CM Group