• Market index enables investors to track the performance of the market, a sector or certain asset class
  • ETFs tracking the S&P/ASX 200 by equal weighting compared to market cap will have a vastly different outcomes
  • Investors should do their homework to know what they are investing into with ETFs tracking indexes

How well do you know your market indexes (or indices)? What even is a market index?

Global X Australia Head of Investment Strategy Blair Hannon told Stockhead having an understanding  of  market indexes and how they work is vital for investors in ETFs.

“What are you getting when you buy an ETF and what is it helping you achieve?” Hannon said.

So, let’s start with the basics.


What is an index?

Hannon said an index enables investors to track the performance of the market, a section of the market or certain asset class.

The S&P/ASX 200 tracks the top 200 companies in Australia and S&P 500 tracks the top 500 companies in the US by market cap.

“Most countries that have a stock exchange will have an index tracking their top companies by market cap,” Hannon said.

“Hong Kong has the Hang Seng while in London there is the FTSE 100.

“It can be an indicator of the health of countries largest companies and in turn their economies to a certain degree.”

He said indexes can also track bonds and commodities, while also being more sector specific, like tech, or certain global mining companies, like gold miners.

“You can’t directly invest in an index so the development and rise of ETFs is that they enable an index to be investible.”


Market cap vs equal weighting indexes

Hannon said with market cap indexes the big companies at the top will drive more of the outcome of the ETF because they will have heavier weightings.

“Equal weight index is where every stock has an equal weighting,” he said.

“An ETF tracking the S&P/ASX 200 with equal weighting as opposed to an ETF tracking the S&P/ASX 200 by market cap will have a vastly different outcome.”

Who makes an index?

Hannon said there are three large financial index providers globally including:

  • S&P Dow Jones
  • MSCI
  • FTSE Russell

S&P Dow Jones is the largest of the big three index providers and well recognised for the iconic financial market indicators, such as the S&P 500 and the Dow Jones Industrial Average.

“MSCI was a business inside Morgan Stanley and rolled out to be independent and is very well known for a global focus,” Hannon said.

The MSCI World Index is a broad global equity index representing large and mid-cap equity performance across 23 developed markets countries.

The MSCI ACWI Index is designed to represent performance of the full opportunity set of large and mid-cap stocks across 23 developed and 24 emerging markets.

They also have the MSCI Emerging Markets Index capturing large and mid-cap representation across 24 Emerging Markets (EM) countries.

“The smaller one of the big three is FTSE Russell which is more dominant in Europe but also boasts the well known Russell 2000 index in the US,” Hannon said.

“Then you have other players in the market like Bloomberg which do specialist income and bond indexes and Morningstar who are playing in the space.

“Some of the recent entrants (such as) Solactive … lean more towards thematics and tailor made indexes where other big players may not play.”


How ETFs track an index

Hannon said ETF issuers like Global X, BetaShares, Vanguard, iShares or VanEck,  have two options regarding tracking an index.

He said they can issue an ETF based on an index available in a particular country.

“The issuer can go to the index provider, ask if it’s available in Australia or see if anyone else is already tracking it for example and simply buy the index off the shelf and issue an ETF based on it,” he said.

“The majority of ETFs are based on indexes already in place.

“If you have an established index, especially that has been created into an ETF offshore,  it’s a reasonable sign that index works and resonates with investors.”

Hannon said the second option for ETF issuers is working with an index provider to custom build an index for an ETF product.

“An ETF issuer may want a different set of rules for a particular ETF rather than say just market cap,” he said.

“You may want an index for an ETF that caters for example Australian investors in a particular thematic or sector so you will work with an index provider to build out this methodology.”

Hannon said when you get into more nuanced or thematic ETFs like the Global X Green Metal Miners ETF (ASX:GMTL) there may be different rules like:

  • Resource rules – only companies mining certain resources
  • Revenue purity – only companies generating majority revenue from certain resources

“You will work with the index provider to make sure it caters for investors in your market and US, Europe and Australia might be slightly different in those cases,” he said.


Do your homework with indices

Hannon said it is important investors understand what they are getting when investing in ETFs tracking indexes.

“If you’re investing in an ETF, a majority of the time it is going to be passively tracking an index so understanding what you are buying is important,” he said.

“Is it market cap and what does that mean in terms of investment outcomes?”

“What are you actually getting with these products and what is it helping you achieve.”

Hannon said the surge of interest in ETF investing shows no signs of abating and just like any other form of investment, there’s always going to be risks and rewards.

“Investors should do their due diligence before jumping on the bandwagon and choose ETFs that align with their overall investment strategy and goals,” he said.