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Understanding Indexes and How Funds Use Them

By Matthew Thornton

January 28, 2021

Market indexes are one of the most visible elements of investing. Numbers from the S&P 500 or the Dow Jones Industrial Index frequently feature prominently in headlines about the US stock market.

Beyond the well-known indexes that we encounter daily lie more than three million indexes designed to reflect the performance of underlying investments, from broad markets to niche subsegments. Indexes vary widely with regard to their specific objectives, the methodologies on which they are built, and the underlying investments they reflect. At the same time, they each have design, administration, and governance features that guide their creation and ongoing operations, and they are not purely objective, self-contained, predetermined constructs.

Indexes do more than serve as a proxy for market performance. For funds, advisers, and investors, they can offer a benchmark for evaluating the performance of actively managed funds, a template for constructing index funds, or even a tool for regulatory agencies.

Finally, evolving investor demands have shaped the fund and index industries in similar and interconnected ways. For instance, the rise of ESG and smart beta investing have spurred innovation and growth in investment strategies, funds, and indexes.

Increased Interest

As the connections between indexes and market activity have become more apparent, policymakers, regulators, and other financial market observers have shown an increased interest in indexes, index providers, and the ways funds and investment managers put indexes to use. Electric vehicle maker Tesla’s entry into the S&P 500 in late 2020 drew attention to index inclusion criteria and rebalancing and showed that index methodologies can be both art and science. And actions taken by index providers in response to the Trump administration’s executive order prohibiting transactions in certain Chinese securities by US persons demonstrated how emerging policy issues intersect with index providers’ work.

To properly ground discussion and examination of issues surrounding indexes, ICI published a primer to provide both investors and regulators information about indexes and the ways funds and their advisers use them.

Background Information on Indexes

ICI’s paper provides an overview of the marketplace for indexes. To aid in a general understanding of how indexes work and how they get used, it also describes:

  • Common features of indexes, illustrated with prominent examples
  • The contractual relationships between index providers and fund complexes
  • How and why an index gets created, and the role that fund advisers may play in that process

How Funds Use Indexes

The paper also details some of the principal ways that funds, advisers, and other parties currently use indexes:

  • Performance assessment—Indexes offer a convenient benchmark against which investors, fund managers, and third parties can measure the performance of a fund.
  • Regulatory purposes—Regulatory agencies such as the US Securities and Exchange Commission (SEC) require funds to use indexes in certain contexts (e.g., in certain performance presentations, or to calculate performance-based fees, for those funds that pay them) and permit funds to use them in others (e.g., a fund may use a “designated index” to comply with a leverage limit in the rule governing funds’ use of derivatives).
  • Portfolio construction, management, and investment policies—To varying degrees, indexes may influence funds’ portfolio construction and management, with indexes most significantly affecting index funds.
  • Multi-asset class portfolio construction—Certain funds such as balanced funds or funds of funds may use indexes as proxies for the asset classes contained within the funds themselves and then implement their asset allocation strategies using active or passive strategies or funds.

Read the primer on indexes and how funds use them.

Matthew Thornton is an associate general counsel at ICI.

Permalink: https://www.ici.org/viewpoints/21_view_indexprimer

TOPICS: Equity InvestingExchange-Traded FundsFinancial MarketsFund RegulationIndex Fund

2020 Annual Report to Members: Roundtable: The Fund Industry’s Response to COVID-19

By Patrice Bergé-Vincent, Marty Burns, and Susan Olson

January 19, 2021

For the 2020 Annual Report to Members, three members of ICI’s leadership sat down to share their thoughts on how the Institute and the fund industry have navigated the COVID-19 crisis.

Read more…

TOPICS: Financial MarketsFinancial StabilityFund RegulationGlobalGovernment AffairsICI GlobalIndex FundInternationalInvestor ResearchMutual FundPolicy ResearchRetirement PolicyShareholder

2020 Annual Report to Members: A Conversation with Paul Schott Stevens

By Paul Schott Stevens

January 14, 2021

Paul Schott Stevens, ICI’s longest-serving chief executive, retired at the end of 2020. As he neared the end of his 16 years of service, he sat down with ICI staff to discuss the events of his tenure.

Read more…

TOPICS: Financial MarketsFinancial StabilityFund RegulationGlobalGovernment AffairsICI GlobalIndex FundInternationalInvestor ResearchMutual FundPolicy ResearchRetirement PolicyShareholder

2020 Annual Report to Members: A Letter to ICI’s Membership

By George C. W. Gatch

January 11, 2021

2020 will go down in history as a year that none of us can ever forget. It was a year of turmoil, fear, and reckoning. Yet for the regulated fund industry, it also proved to be a year of resilience, transition, and great hope.

Read more from ICI Chairman George C. W. Gatch’s letter that was released in ICI’s 2020 Annual Report to Members.

Read more…

TOPICS: Financial MarketsFinancial StabilityFund RegulationGlobalGovernment AffairsICI GlobalIndex FundInternationalInvestor ResearchMutual FundPolicy ResearchRetirement PolicyShareholder

ETFs Are Passing the COVID-19 Crisis Test

By Shelly Antoniewicz

March 17, 2020

How have exchange-traded funds (ETFs) weathered the intensifying financial market fallout from the COVID-19 pandemic? So far, it looks like ETFs are healthy and robust.

Read more…

TOPICS: Equity InvestingExchange-Traded FundsFinancial MarketsFinancial StabilityIndex FundTrading

2019 Annual Report to Members: A Letter to ICI's Membership

By George C. W. Gatch and Paul Schott Stevens

November 14, 2019

What follows is an abridged version of a letter by ICI Chairman George C. W. Gatch and ICI President and CEO Paul Schott Stevens that was released in ICI’s 2019 annual report. To read their full letter, please see ICI’s 2019 Annual Report to Members....

Read more…

TOPICS: Financial MarketsFinancial StabilityFund RegulationGlobalGovernment AffairsICI GlobalIndex FundInternationalInvestor ResearchMutual FundPolicy ResearchRetirement PolicyShareholder

Understanding Interest Rate Risk in Bond Funds

By Shelly Antoniewicz and James Duvall

December 17, 2018

Long-term interest rates reached their lowest recorded levels in July 2016 and were on a steady upward trend until early December. Rates dipped recently, but that could be short-lived if global trade tensions ease and the outlook for economic growth remains robust. Investors should be aware of the effects rising interest rates could have on their bond fund investments....

Read more…

TOPICS: Bond FundBondsExchange-Traded FundsFixed IncomeIndex FundMutual Fund

Fund Adviser Proxy Votes Align with Fund Interests

By Paul Schott Stevens

September 24, 2018

A key assertion in “Cracking the Proxy Racket” (The Wall Street Journal's Review & Outlook, September 18) is that asset managers vote “in block” to support recommendations set forth by advisory firms like Glass Lewis and Institutional Shareholder Services. Such statements ought to be tested against actual data.

A decade’s worth of research shows that fund advisers vote proxies diligently, in line with their fiduciary duty to the fund and its shareholders...

Read more…

TOPICS: Fund GovernanceFund RegulationIndex FundMutual FundProxy VotingShareholder

Pointing Fingers at Index Funds Won’t Explain Market Volatility

By Shelly Antoniewicz

February 14, 2018

With all the recent volatility in the US stock market, two questions are frequently being asked:

  • Are fund investors fleeing the stock market?
  • Are index funds causing market turbulence?

The short answer to both questions is no.

Experience and research show that investor flows to and from mutual funds and exchange-traded funds (ETFs) tend to track market returns. ...

Read more…

TOPICS: Equity InvestingExchange-Traded FundsFederal ReserveFinancial MarketsFinancial StabilityIndex FundInterest RateInvestor ResearchMutual FundTrading

2017 Annual Report to Members: A Message from the Chairman

By William F. “Ted” Truscott

November 13, 2017

This letter by ICI Chairman Ted Truscott was released in our 2017 Annual Report to Members.

Every day, I’m reminded that each of us in the fund industry is driven to deliver ever-greater value for our fees and keep improving service to fund shareholders. Investors are demanding more from every asset manager—and the resulting competition drives us to innovate, find new efficiencies, and offer even better solutions for investors’ needs.

Read more…

TOPICS: Financial MarketsFinancial StabilityFund RegulationGlobalGovernment AffairsICI GlobalIndex FundInternationalInvestor ResearchMutual FundPolicy ResearchRetirement PolicyShareholder

Funds Actively Seek Companies’ Sound Management

By Paul Schott Stevens

July 3, 2017

The following ICI Viewpoints is a letter to the Wall Street Journal by Paul Schott Stevens, president and CEO of the Investment Company Institute, in response to an editorial published on June 22, 2017.

In their muddled and inconsistent arguments, the authors of “Index Funds Are Great for Investors, Risky for Corporate Governance” (op-ed, June 22) rely on unfounded assertions while ignoring clear legal requirements placed on registered funds, their boards, and their advisers...

Read more…

TOPICS: Exchange-Traded FundsFund GovernanceFund RegulationIndex FundMutual FundShareholder

Average Expense Ratios for Index ETFs Have Declined

By Shelly Antoniewicz, Sean Collins, James Duvall, and Morris Mitler

May 24, 2017

In yesterday’s ICI Viewpoints post, we noted that our annual report on the asset-weighted average expense ratios of funds—“Trends in the Expenses and Fees of Funds, 2016”—showed that expenses for long-term mutual funds continued to decline in 2016.

Read more…

TOPICS: Bond FundEquity InvestingExchange-Traded FundsFixed IncomeIndex FundInterest RateMutual Fund

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