Today, there are indexes designed to represent the performance of a wide range of investment segments, including market capitalization, geography, industry and, most recently, factors. They also are used as the basis for financial products, such as exchange-traded funds or derivatives. Much like Adam Smith’s “invisible hand,” they play a critical, behind-the-scenes role, reflecting the entire market’s views on valuations, rather than those of any individual or group of individuals.
Yet, there remains a lot of confusion around the role of indexes. With that in mind, we thought it would be useful to take a step back and answer some basic questions: What purpose does an index serve? Why were indexes created in the first place? And how have they evolved to meet and advance the needs of asset owners?
In the beginning
Indexes were created to serve as a “benchmark” tool for the asset owner community. These large institutional investors were seeking simple, unbiased and transparent ways to measure the performance of their asset managers in running portfolios around the world. Indeed, the broad adoption of indexes as benchmarks standardized performance measurement, and increased the transparency and integrity of financial markets.
INDEXES HAVE EVOLVED TO MEET ASSET OWNERS’ NEEDS
Asset owners take the reins… index providers respond
Not long after, asset owners started to use the composition of indexes not just as a measure, but as a proxy for creating investment opportunity sets. This new practice, in turn, spurred innovation among index providers and resulted in the introduction of what sometimes are known as replicable indexes. The construction of these new tools more accurately accounted for real-world constraints of international institutional investors — including index constituent size, free float and liquidity. In short, they were a better representation of the true investment opportunity set available to large asset owners.
Using broad free-float adjusted indexes, such as the MSCI ACWI Index or MSCI ACWI IMI, as policy benchmarks for the purpose of setting their strategic asset allocation, allowed asset owners to evolve their equity allocation decision-making. No longer were allocations based solely on a manager’s beliefs or even those widely held by the investment community. For the first time, allocations could be balanced to the economic weight of the different regions of the world by using the natural free-float-adjusted market capitalization weights of the different countries and regions in the indexes. Thus, they started playing an important role in the judgment-free capital allocation decision process.
INDEXES’ VALUE CONTINUES TO EVOLVE
More recently, we have seen a number of larger asset owners shift toward alternative indexes, such as environmental, social and governance (ESG) and factor indexes, as their policy benchmarks. These investors aim to tilt their portfolios, and hence their asset allocation, away from pure market-capitalization-based weighting. Instead, they seek to increase long-term risk-adjusted excess returns through strategic exposures to ESG characteristics and/or factors.
The role indexes play in the investment value chain of asset owners, while not always visible, has been critical and developed over time. Looking ahead, index providers likely will continue to play their supporting part, working with international institutional investors and refining indexes to meet an ever-evolving set of needs.