The Measure Of The Market: What Every Investor Should Know About Indices

Ever wondered how investors keep track of the market’s pulse?

In this article, we dive into the world of market indices—what they are, the different types you’ll encounter, and why they matter. We’ll explore the advantages and drawbacks of using indices as investment tools, and explain how we harness indexation to build smart, diversified portfolios for our clients.

What is an index?

A investment index (which could consist of stocks, bonds, or other assets used by investors) is not just a list of investments with specified weights. It’s more than this. Specifically, it’s a set of rules to create a theoretical portfolio – which can be used by investors in many ways.

The investments that comprise an index are often based on characteristics like specific geographies, industries, or sectors. The index performance may be used to describe the overall performance of an asset class (an asset class is loosely defined as a group of investments with similar characteristics, like “global bonds”, for example). An example of a commonly quoted index is the FTSE100, which is made up of the UK’s largest 100 companies. As the price of those companies rise, the FTSE100 index also rises. The FTSE 100 performance is therefore commonly used to describe or generalise about the performance of the largest UK companies.

Because it is theoretical, an index may or may not be “investable.” By investable, we mean usable as a guide for making investments directly. For example, some indices are not investable due to very high daily turnover (trading) needed to align with them, or they may contain assets that an investor cannot buy. Other indices (like the FTSE100) would be considered “investable”, with assets that can be easily traded and rules that allow an investor to follow the index process without incurring excessive costs. Many such investable indices can now be found as the foundation for a variety of ETFs (Exchange Traded Funds), which aim to deliver the underlying performance of the index portfolio to investors.

How are indices used in the investment industry?

Although initially used as a measure of market, sector, or asset class performance (i.e, “benchmarking”), indices are very important for gaining a better understanding of an active strategy, fund, or investment using more complex analytics.

Performance Comparison: Comparing a fund’s performance with the index tells you whether the fund made greater gains or losses than the index. It helps you see if the manager added value through active decisions or just followed the market. This is classic “benchmarking.”
Risk Comparison: Measures how much investment risk (chance of gaining/losing money) the fund is taking compared to the index.
Performance Attribution: By comparing a fund’s return to the benchmark index, you can understand what caused the relative gains or losses — was your performance a result of bets on specific stocks, or sectors, or something else?
Risk Attribution: Looks at what kinds of risks the manager is taking—are they different from the average in the market? A fund might generate a higher return over a specific period, but only because it took bigger risks.

Finally, investable indices can be found as the basis for “passive funds” and ETFs, which are the investment vehicles used by investors.

Remember, an index is a theoretical set of rules, not an actual asset – to try and capture its performance, you need to put your money in an investment vehicle (such as a fund) that buys the assets in the index!*

How are indices constructed?
Understanding how an index is built is key, as its design affects how you should use it for performance and risk comparisons – the devil is in the detail. Let’s focus on equity indices, which track groups of companies. Indices in other asset classes like bonds or alternatives (e.g. real estate) are built differently and come with their own challenges.

Most major stock indices use market capitalisation weighting. This means each company’s size in the index is based on its market value, which is calculated by multiplying its share price by the number of shares it has issued. Therefore, larger companies like Apple or Microsoft have more influence on the index’s movements than smaller ones. This method is widely used because it reflects the real size and importance of companies in the market and is easy for large funds to track and invest in.

[Note: Some indices refine this further using free-float market capitalisation. This only includes shares available for public trading, excluding those held by insiders, governments, or long-term investors. This gives a more realistic view of what investors can actually buy and sell.]

The evolution of indices
Indexing has changed a lot over time. It started as a simple tool to track how groups of investments like national stock markets (think FTSE100) or industry sectors (think the Dow Jones Industrial Average) were performing.

While initially used primarily as a measurement tool, advances in technology (for calculation and trading) started to allow investors to invest in index portfolios, allowing individuals to gain broad access to different asset classes without using an active portfolio manager. As technology and research continued to advance, this led to the development of so called “smart beta” indices. “Smart beta” indices follow pre-defined rules e.g. selecting companies based on certain qualities like how much their prices have gone up recently (this factor is known as price momentum). The idea is that smart beta can add investment value using a simple, rules-based approach to active management, while keeping costs low.

As a current example, WTW** has partnered with MSCI (a leading provider of index data) to create GEDI (Global Equity Diversified Index), a multi-factor strategy aimed at delivering long-term returns efficiently. By integrating proven investment approaches with environmental objectives and disciplined risk control, GEDI demonstrates how index design can support both financial goals and sustainability values in a practical, client-focused way.

Another development is the rise of thematic ETFs (or exchange-traded funds) that follow indices built around specific trends such as clean energy, artificial intelligence, or healthcare innovation. These allow investors to target areas they believe have strong growth potential, rather than investing in the broader market.

Thanks to innovations like these, indexing has become more flexible and accessible. Investors can now choose from a wide range of strategies and themes, often at low cost, to align with their financial goals and market views.

Common alternatives to market cap-weighted indices
While market cap-weighted indices are the most common, there are other ways to build an index, each with its own pros and cons:

Price-weighted indices (e.g. Nikkei 225, a Japanese equity index) if you buy one share of each stock, the index gives more weight to companies with higher share prices, regardless of their size. They’re simple to calculate—just the average of stock prices—but don’t reflect a company’s true size or importance and was developed when computers weren’t available to handle more complex calculations.
Equally weighted indices are where every company in the index is given the same weighting, regardless of its size. This method is often used when investors are concerned about concentration risk—when a few large companies dominate the index. This approach spreads exposure evenly but assumes all companies have equal future potential. It also requires frequent rebalancing (buying and selling), which can increase trading costs. It can be viewed as an active strategy, as it will buy stocks that go down and sell stocks that go up at each rebalancing point.
Systematic strategy indices reflect a modern approach to indexation. Thanks to advances in computing and data, it’s now possible to create indices based on almost any set of rules. This rules-based method is used to target specific investment styles, such as undervalued stocks or companies with strong earnings. Often used in smart beta strategies, they aim to enhance returns or reduce risk relative to a market cap weighted benchmark. They should be classified as active strategies due to more frequent trading and active, though automatic and predictable decision-making.

How different can these approaches be? Let’s consider a simple world with three stocks. Stock A has a high price, but not many shares outstanding and therefore has a small market capitalisation (the value of all outstanding shares). Stock C has a low share price, but a lot of shares outstanding and a high market capitalization – it would take more money to buy Company C (in its entirety) than company A – and has a lot of positive factor characteristics (like momentum or quality). And company B is somewhere in the middle of the pack. The weights of stocks in the different indexes you may consider might look something like this:

The charts illustrate how the different index types assign weights to companies:

Market Cap-Weighted indices prioritise firms with greater total market value e.g. Company C.
Price-Weighted indices favour companies with higher share prices, e.g. Company A.
Equally Weighted indices treat all companies the same.
Systematic Strategy indices allocate weights based on specific factors like value or momentum, favouring companies with stronger scores, e.g. Company C

Our approach to indices

Our view is that market cap benchmarks are a useful reference point for evaluating the performance of an investment strategy, fund, or process, as they reflect the returns of the broader market. We often use them when monitoring our fund managers, and particularly where we are using active management to outperform the benchmark.

Their key benefits from an investment standpoint include being able to access a broad set of investment returns while keeping turnover and therefore cost low. On the other hand, their natural tendency to become concentrated, not be risk managed, and potential for market participants to anticipate rebalancing (which is true for all indexed products) means they must be used wisely. As such, we believe a blended approach that combines passive investing (using market cap-weighted indices) with active management (which includes systematic strategy indexing used for smart beta strategies as described above) can help mitigate these drawbacks and support more diversified, resilient portfolios.

This combination of indices fits with our goal of using a blended investment approach that combines active, smart beta, and passive strategies to balance performance and cost within an investment portfolio. Active managers bring expertise and flexibility to respond to market changes and aim to outperform benchmarks. Smart beta funds apply rule-based strategies, like focusing on undervalued or high-performing stocks, to capture active-style returns at lower cost. Passive funds provide broad market exposure efficiently and inexpensively. This mix allows us to diversify sources of returns while ensuring fees are only paid where we believe they add clear value.

* We note that large, institutional investors can also gain exposure to indices thought derivatives like swaps and futures contracts, which is beyond the scope of this piece. The vast majority of retail investors will gain exposure via investing in a fund.

** WTW (formally known as Willis Towers Watson) is a global financial service firm that atomos formed a strategic alliance with in 2023 in relation to our investment proposition.

Disclaimer

Any views expressed are based on information received from a variety of sources which we believe to be reliable, but are not guaranteed as to accuracy or completeness by atomos. Any expressions of opinion are subject to change without notice.

All investment views are presented for information only and are not a personal recommendation to buy or sell. Past performance is not a reliable indicator of future returns, investing involves risk and the value of investments, and the income from them, may fall as well as rise and are not guaranteed. Investors may not get back the original amount invested.