Explainer: What is an index?

Stock market indices are the foundation on which low-cost passive investment strategies, such as ETFs, are built. CoreShares and EasyEquities recently hosted a webinar to explain how they work and the different functions they serve.

An index measures the value and performance of a collection of stocks. The S&P 500 index, for instance, measures the performance of the 500 largest publicly traded companies in the US. These investable, theoretical portfolios give investors an overall view of the market, and allow them to gauge the relative performance of specific stocks or portfolios.

In South Africa, the JSE Top 40 is the best-known index. It includes the 40 largest companies listed in Johannesburg.

Traditionally, indices are weighted by market capitalisation – meaning the largest companies are the most prominent constituents. In the case of the JSE Top 40, Naspers accounts for a larger share of the index than Woolworths, due to its size. As a result, the index will be more influenced by changes in Naspers’ share price than Woolworths’.

While indices were initially designed to act as performance benchmarks, they are now widely used in the construction of passive investment strategies.

Exchange-traded funds (ETFs) and unit trusts mirror the performance of underlying indices by buying stocks and holding them in a portfolio that has exactly the same weightings as the index itself.

Passive investment strategies have surged in popularity over the past two decades as investors pay closer attention to fees. Market participants have also come to realise that it is difficult to identify stocks that will deliver superior returns over the long run, and as such, it is beneficial to invest in the market as a whole.

The rise of ETFs and unit trusts has allowed non-professional investors to manage risk by gaining exposure to a wide range of companies through a single, highly transparent index-tracking vehicle.

And by pooling the resources of many investors to achieve economies of scale, they significantly reduce investment costs – a key determinant of outperformance. In fact, studies show that very few professional investors are able to consistently beat the market after taking costs into account.

Industry developments

Indices and passive investment strategies have evolved significantly over the past 20 years or so.

For instance, the CoreShares Top 50 ETF, which tracks the S&P South Africa 50 Index, is constructed in a way that no stock can have a weighting of more than 10%. This reduces concentration risk and enhances diversification.

In short, an index is a  theoretical collection of stocks that is used as a market barometer. An ETF, on the other hand, is an investable vehicle that replicates and tracks the index.

We invite you to watch this on-demand webinar to explore these concepts further:

Featuring

Overview

Speaker Chris Rule CoreShares Read Bio Prior to CoreShares, Chris spent time at Grindrod Bank where he was primarily involved in balance sheet projects and fund management. He was instrumental in the development and growth of Grindrod Bank’s ETF business (the precursor to CoreShares) and is currently responsible for product development, research and all capital markets activities. He has over 9 years’ financial services experience across investment management and investment banking. Chris holds a B.Comm.Hons (Financial Analysis), and is a CFA charterholder. Close Bio

What is an index? Learning outcomes: The definition of an Index Understand the connection between ETFs and Indices Work through a simple example of each Learn why “diversification is the only free lunch in investing” Register

To learn more on how to decide which ETFs to buy or sell, watch the 3rd installment in our webinar series.