This is not about your father's index.

The quaint notion many investors and financial advisors have of index-based investment vehicles is born out of the days when index-based mutual funds or exchange-traded funds simply replicated the performance of a broad market or capitalization range. This is inconsistent with today's reality.

The index-based investment products landscape has changed significantly in the last decade. Fund managers, financial advisors and investors all need to understand how these new indexes work in order to create better products and determine what role they may play in an investment strategy.

More Powerful Tools at Your Disposal

The depth and breadth of indexes has changed significantly in recent years, as index developers and investment product providers have moved beyond static market cap approaches to more dynamic strategies such as certain factor exposures, alternative weighting strategies and approaches that mimic styles of investing such as growth-at-a-reasonable-price (GARP) or equity income.

The result is that index-based investment vehicles can be used for much more than simply benchmarking or replicating the performance of a broad market or asset class. Within a client portfolio, the index approaches of today can help you efficiently allocate assets toward areas where you see growth potential, isolate and manage market risk and diversify assets. This growing utility for index-based investment strategies, along with the advent of ETFs, has fueled increasing interest and asset growth in this area. This in turn has increased the need for even greater education about these new indexes.

Growing Popularity Drives Need for Greater Education

In the last decade or so, indexes have also moved aggressively into a new phase of development, which can be referred to broadly as "rules-based strategies". While still having the traditional index characteristics of being rules-based and transparent, these new indexes behave more like active strategies.

Rapid innovation in the index world means that financial advisors now have a very efficient way to deliver an actively managed asset allocation model to clients. The transparency and consistency indexes offer make them ideal for investors who want to assemble a portfolio with exposure to various asset classes or investment styles, but without the added cost and effort to evaluate and select active managers.

However, for many investors and financial advisors these new strategies may seem opaque, complex and difficult to understand.

Fund managers and financial advisors need to understand index-based products thoroughly in order to fully harness indices and put them to work for clients.

Asking the Right Questions

Financial advisors, fund managers and investors can benefit from a primer on the new categories of indexes in the marketplace being offered within investable products. Here are just a few of the newer index-based investment strategies and the potential value they can offer within a broadly diversified portfolio:

* Lowering Portfolio Volatility. New index- based investment approaches allow you to isolate a certain investment factor, such as low volatility and momentum. This can help you weight your client's portfolio toward a certain factor, either opportunistically or to hedge another part of the portfolio or the broad market. For example, your client may be interested in gaining exposure to small cap stocks, but are concerned about greater historical volatility in this asset class compared to large cap stocks. The Russell-Axioma U.S. Small Cap Volatility Index, for example, returned 3.2% on an annualized basis for the five years ended 12/31/11, relative to a 0.1% annualized return for the Russell ® 2000 Index, with a corresponding annualized standard deviation of 18.7% compared to 24.5% for the Russell 2000® Index.

* Replicating an Active Investment Strategy. New index-based investment approaches allow you to access the broad characteristics of a particular style of active management through an index-based approach. You may believe in a certain style of active portfolio management, but are concerned about picking the right manager. The Russell Investment Discipline Indexes, for example, seek to replicate the broad characteristics of various active manager strategies such as U.S. Large Cap Low P/E, U.S. Large Cap Equity Income or U.S. Small Cap Aggressive Growth.

These are just two of the ways the new generation of index-based products may help financial advisors meet client portfolio challenges. Anyone trying to create funds, manage funds or help clients select funds should become familiar with the basics of these and other emerging indexbased investment strategies.

Financial advistors in particular will need to be just as watchful when evaluating index-based investments as when they are evaluating any investment for a client. In the case of the newer more progressive strategies, it is crucial that you focus on important factors for a client such as underlying fees, frequency of rebalancing, specifics to index construction and methodology and, in the case of an ETF or mutual fund, which is based on an index, tracking error relative to the underlying index. New innovation in the index world means a broader set of tools for financial advisors, but also calls for more education and context in evaluating which strategy is right for your client.

Ken O'Keeffe is managing director of investable products for Russell Indexes, a pioneer and leader in the field of global index construction and methodology.

Subscribe Now

Access to premium content including in-depth coverage of mutual funds, hedge funds, 401(K)s, 529 plans, and more.

3-Week Free Trial

Insight and analysis into the management, marketing, operations and technology of the asset management industry.