3: How do indexes work?

Currently all exchange-traded funds (ETFs) are based on indexes: lists or methodologies which determine the composition of a basket of stocks or other assets. Understanding them is crucial because they drive ETFs’ performance.

  • Most indexes (aka 'benchmarks') are created by third parties such as Dow Jones or Standard & Poors. These providers often have slightly different methodologies for composing indexes that represent the same investing targets (e.g. ‘large cap value’ or ‘small cap growth’), so the performance of ETFs with similar targets may differ.

As the popularity of ETFs has grown, ETF sponsors have rolled out increasingly more creative and targeted indexes to provide investors with specialized investing vehicles. For example:

  • ETFs that modify traditional indexes in the hope of achieving better returns. Broad stock indexes such as the S&P 500 have traditionally been ‘cap-weighted,’ that is, the representation of stocks in the basket is determined by their market capitalization. Some ETFs indexes are now using other weighting criteria such as dividends or earnings.
  • ETFs whose index composition changes frequently (e.g. monthly) in an attempt to emulate active management.
  • ETFs based on other themes, strategies, or criteria, such as sector rotation or insider buying behavior, spin-offs, patent holdings and so on.
  • ETFs whose indexes magnify the performance of a given set of securities using leverage, or provide the inverse return of that performance (shorting), or both.