What is an Index?
Indices are all around us. The index in a book. The Cost of Living Index. The Consumer Price Index. The Index of Leading Economic Indicators (my fave). Index fingers. Except for the index in a book and your finger, indices are used to measure something.
Index is a jargony word in financial terminology. It is one of the words that people, including me, use without thinking. But I thought back to a time when I did not really understand what a financial index was and when I nearly had a very embarrassing moment in front of my colleagues.
In every aspect of life, we are comparing one thing to something else. We have “gold standards” (not real gold) and Best of the Best lists.
I recently had to buy a new printer. Recently, as in today , because I wasted a couple of weeks thinking I could fix it. It could be fixed but it would cost more to fix than a new printer.
I had no idea how to choose or compare printers. I read reviews on different sites. I read the technical specifications. Did I want to be able to print, scan, fax, and email? Did I want an ink jet or a color laser? How many sheets per minute did I want to print? Did I want a printer that has Bluetooth and network capabilities? The list was endless and so were the choices.
The printer experience is not unlike comparing mutual funds or exchange traded funds. As an investor you want to know what the characteristics of the fund are before you invest. But how do you narrow down the choices?
Comparing the performance of a fund to an index is one way.
An index is a list. The list is made up of stocks or bonds that are grouped by specific characteristics.
The S&P 500 Index is a list of the largest publicly traded companies in the U.S.
The index does not “do” anything. No investment decisions are made. No one is managing it. You cannot invest directly in an index.
The index is like a neutral third party. When potential investors in a fund want to compare the performance of one fund to another fund, using an index makes comparisons easy .
There are hundreds of indices. There is an index to measure an intermediate maturity bond fund. There is an index to measure small cap stocks. There is an index to measure emerging market stocks or global stocks.
Indices are used for every asset class. Real Estate, Commodities, Private Equity and Alternatives.
This is how you would phrase a question to compare an index to a fund.
“What is the performance of the S&P 500 index versus the performance of the XYZ S&P 500 fund.”
For example: the performance of the index is 5%. The performance of the fund is 6%. This means the fund has returned 1% more than the index. That is a good thing.
If the performance of the index is 5% and the performance of the fund is 4%, the fund underperformed the index by 1%. Not so good.
An index is especially useful when measuring long time periods.
“What is the performance of the S&P 500 index versus the S&P 500 fund over 3,5- and 10-year periods ?”
Ideally the performance of the fund should closely track that of the index through all time periods.
Here is where it gets tricky for individual investors. Individual investors are not taught to think in terms of performance versus an index. Your broker might call you up and say
“ Your fund returned 8%.”
Your reply is: “what was the performance versus the index?” . If the index returned 10% and the fund returned 8% , that is not the outcome you want.
Here is the almost embarrassing moment in front of my colleagues. Investment managers track the performance of the funds they manage versus an index, daily. The important date though, is the month end date because that is the number investors will see.
In one of our weekly meetings on the first of the month, one of the managers asked if anyone has seen the performance numbers for one of our largest funds.
I jumped in and said “yes, the performance of the fund was 3%”
And he said, “absolute or relative?” Okay I admit I wasn’t thinking in those terms specifically. I had to think, relative to the index ? Did I look at the index? Oh right, the index numbers had not been published yet.
Powers of deductive reasoning kicked in and I responded 3 excruciating seconds later “absolute”.
“Absolute” to an investment manager is a meaningless number so I just wasted everyone’s time thinking I had the answer. Mildly embarrassing but a good lesson.
Performance only matters if it is compared to an index.
Index of Leading Economic Indicators
History of the S & P 500 Index
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