Index investing continues to grow in size and scope. The Morningstar Principia database shows that about 15% of distinct portfolios are index-based products. These funds are either open-end index funds or exchange-traded products (ETPs) that track indexes. Together, index-based funds represent more than 20% of the value of all funds in the database.

As this segment of the market grows, so does the complexity of the indexes. There are now hundreds of sophisticated indexes whose construction and purpose bears little resemblance to traditional benchmarks such as the Russell 3000. These new methods include quantitative security selection and alternative weighting strategies.

Today's advisors can best serve their clients with a working knowledge of the various index methodologies. Unfortunately, this is no easy task. There are simply too many indexes and strategies available. We need new tools to make the analysis of index-based products faster and easier.

This article provides a powerful new tool for analyzing index-based products: an Index Strategy Map with nine Strategy Boxes that categorize index-based products by the investment strategy used in their underlying indexes. The map will help advisors quickly determine how securities are selected and securities weighted in an index. This analysis provides a portal to how fund managers run their funds and a new route to comparative analysis.

Advisors will begin to notice index strategy map information as several database providers incorporate this tool as part of their research and product providers add the information in their marketing materials. This article is written as a primer on the subject, with more detailed information available in The ETF Book, written by the author.

THE EVOLUTION OF INDEXES

The SEC does not regulate the definition or structure of an index. It views an index as a basket of securities that are selected, weighted and maintained according to a published set of rules. Hence, the traditional view of an index as being a passively selected, capitalization-weighted basket of securities that represents a market is no longer valid. Today, index funds and ETPs track two types of indexes: benchmark indexes that follow traditional methods and strategy indexes that do not.

Investors use benchmark indexes to measure wealth. They capture broad groups of securities and weight them according to their market capitalization in order to form a single representative value for the securities measured. A benchmark index is primarily a measurement tool, a yardstick that represents the dollar value of a market, whether it be equities, fixed income, currencies or commodities.

Benchmark indexes are important financial indicators. They are used at the highest level of economic analysis, at the U.S. Federal Reserve and all other central banks. They are also widely accepted by top academic institutions and are referred to extensively in research papers. Virtually every asset allocation decision made by individual or institutional investors relies on benchmark indexes for data input. In addition, benchmark indexes are the standard against which all active management strategies are measured. Last, over the past 30 years benchmark indexes became a dominant tracking tool used by index fund managers.

The methods used to create strategy indexes differ from those used to develop benchmark indexes. Strategy indexes are meant to be used as the basis for alternative products that compete against benchmark-index-based products. They do so through an alternative security selection methodology, modified security weighting methodology or both. Often it's the prospective fund company that approaches the index provider to create the strategy index and manage it when a product launches. Although strategy indexes are not benchmark indexes, their performance is often compared with that of benchmark indexes in marketing materials.

Benchmark and strategy index products compete for space in the index fund and ETP market. Benchmark index products still dominate by market value, but strategy indexes are capturing a growing market share as hybrids between benchmark index products and actively managed products.

INDEX STRATEGY MAP

Index strategy has become complex, and the tools available for analysis must advance to the same level. The index strategy map addresses this. The classification method divides all index strategies into nine distinct boxes. This provides a framework for differentiating one index strategy from another and helps investors compare and contrast various index products.

Index providers publish rules for the construction and maintenance of every index, typically via a methodology handbook on the provider's website. Not all index providers are equally forthcoming with their methods; however, there is generally enough information available to categorize index products.

The index strategy map was created to categorize the methodologies that index funds and ETPs attempt to track. The classification system helps investors quickly grasp how a product's underlying strategy differs from benchmark methodology and how two similarly named products might be quite different. For example, index strategy boxes can be used to sort and compare the performance and fees of funds that follow similar rules.