This essay is part of a two part series on indices. In this article, we discuss what exactly indices are, their specific traits, and provide some definitions for tracking error. This article is intended for those without a strong traditional finance background. For those who understand indices, how they are constructed, and their costs are encouraged to just skip to our next article which discusses the importance of indices for digital assets.

Introduction

An index is a rules-based basket of securities designed to measure the performance of the market, market sector, investment style, or strategy. The first index was Charles Dow’s 11-stock railroad index in 1884 that evolved into the Dow-Jones Industrial Average in 1896.

Pooled investing in mutual funds enabled small investors to participate in a selected subset of the market (determined by the mutual fund) with the benefits of diversification plus lower expenses (ref: ETF primer). Mutual funds were actively managed according to a style set out in their prospectus (e.g., U.S. small cap growth, dividend, or value). Comparing mutual fund performance across funds was difficult because of style-drift (e.g., large cap stocks in a small cap mutual fund) and the lack of benchmarks for the style. Initially, there were no benchmarks and companies like Morningstar, providing reviews of mutual fund performance, holdings, fees, and adherence to style advertised in their prospectus, did not exist. Standard Statistics published a 233-stock weekly index from 1923 that was revised and renamed Standard and Poor’s 500 stock (S&P 500) index in 1957. Other indices were published: Lehman Brothers Aggregate Bond Index (1973), FTSE (UK large cap) and Russel 2000 small cap indexes (1984) and Goldman Sachs Commodity index (1991).

While initially benchmarks for active mutual funds and managers, the indices were used for passive investing. In 1976, Vanguard created the Vanguard 500 Index Fund that replicated this index within a mutual fund and with markedly decreased expenses, due to elimination of stock research analysts. The performance of Vanguard 500 Index Fund showed that low-cost passive investing outperforms the vast majority of active fund managers.

Exchange-traded funds or products (ETFs) improved upon index mutual funds by lowering costs further and by being tradable throughout market hours (ref ETF primer). The mechanisms of ETFs are described in (ref ETF mechanisms). In 1993, the SPDR S&P 500 ETF (SPY) was launched followed by a plethora of ETFs based on indices and selected assets (e.g. QQQ:NASDAQ; BITO:BTC, TLT:30Y treasury, etc.). ETFs have driven the creation of novel indices to achieve a variety of investing goals.

Today, index creation is still a complex and lively industry, with professionals working to create indices in new markets with evolving construction criteria. In the following sections, we will cover the difference between index types and then continue to their impact on markets.

Executive Summary

An index is a rules-based basket of securities designed to measure the performance of the market, market sector, investment style, or strategy. Indices are defined by their: (i) universe definition, (ii) selection rules, (iii) securities weighting schemes, (iv) rebalancing and reconstitution schedules, and (v) handling of corporate actions. The Universe Definition of the index defines the pool of securities that the index may hold, the listing venue (e.g., NYSE and/or NASDAQ), geography limits, and the liquidity tests. Selection Rules, which filters down the pool of securities that the ETF may hold to the official constituent security list, ensures the selected stocks for the ETF are consistent with the benchmark and without bias. Selection rules include: market cap, factor, and sector screens. The Weighting Scheme assigns a weight factor for each constituent security in the index. The Rebalancing Schedule determines how often the index updates its weighting schedule and the components of the index. Handling of Corporate Actions defines how dividends, splits, spin-offs, mergers and acquisitions, rights, etc will be handled within the index.

Major Index Categories

Objective	Example	ETF
A: Asset class
1.  Equity	S&P 500, NASDAQ 100	SPY, QQQ
2.  Fixed income	ICE US Treasury 20+ Year Bond Index	TLT
3.  Commodity	S&P GSCI	GSG
B: Geography
1. Country	MSCI Japan Index	EWJ
2. Region	MSCI EM Asia Custom Capped Index	EEMA
3. Global	S&P Total Market Index	ITOT
C. Style or factor
1.  Weighting	NASDAQ-100 Equal Weighted Index	QQQE
2.  Value, growth, momentum, etc.	S&P 500 Value Index	IVE
3. Dividends	Morningstar Dividend Yield Focus Index	HDV
D. Sector or theme
1.  Global industry classification	NYSE Arca Gold Miners Index	GDX
2.  ESG	S&P Global Clean Energy Transition Index	ICLN
3.  Themes (AI, blockchain, etc)	NYSE Semiconductor Index	SOXX
4. Leverage/option writing		SDS, BMAY

The table above lists the major index categories but these intertwine. For example, S&P 500 ETFS (e.g. SPY) hold equities (asset), track US-only assets (geography), is market cap weighted (style), and only holds large caps (sector).

Index Construction: How Indices Are Defined

Indices are defined by their: (i) universe definition, (ii) selection rules, (iii) securities weighting schemes, (iv) rebalancing and reconstitution schedules, and (v) handling of corporate actions.

Universe Definition

Each index defines the pool of securities it may hold, selecting based on the listing venue (e.g., NYSE and/or NASDAQ), geography limits, and liquidity tests. Setting the pool of securities too broad (all micro-cap stocks) makes the index uninvestable as trading costs scale with each additional underlying. The liquidity tests for the index determine whether an ETF that tracks the index can trade the constituent securities without substantially moving the market in those securities. The liquidity tests include: (1) absolute turnover test (dollar liquidity and share count); (2) turn-over ratio filters; (3) trading frequency filters; (4) days to liquidate filters. The higher the liquidity test results, the better the ETF tracks the index in real market conditions. Collectively, the Universal Definition gauges whether the ETF is investable.

Selection Rules

These filter down the pool of securities that the ETF may hold to the official constituent security list, ensures the selected stocks for the ETF are consistent with the benchmark and without bias. Selection rules include: market cap, factor, and sector screens.

Weighting Scheme

The weighting scheme assigns a weight factor for each constituent security in the index. Weighting schemes include: (i) market capitalization, (ii) price, (iii) equal, (iv) risk (inverse volatility), and (v) factor-tilted (e.g., value, volatility, and fundamentals). The choice of weighting scheme has important consequences for the index. Market cap weighting results in concentration in the largest securities and decrease diversification, whereas equal weighting diversifies the index but the market leaders may outperform the smaller laggards.

Rebalancing Schedule

Each index must determine how often it updates its weighting schedule and the components of the index. The frequency may be daily, monthly, quarterly, semi-annual, annual or never. The rebalancing schedule may be according to fixed set of rules for the index or determined by active managers. Rebalancing results in (i) costs, and (ii) turnover with an increased frequency eliciting trading fees but also a closer adherence to the index. The rebalancing scheme may include buffers so that securities that fall just the index threshold are not eliminated just to be replaced in the next cycle if price recovers. Buffers minimize whipsaws and costs of eliminating one security to purchase a new position. Reference dates determine how long the look-back period is for rebalancing; the reference dates may be the average volume or snapshots at a set time.

Handling of Corporate Actions

Corporate actions impact holdings through dividends, splits, spin-offs, mergers and acquisitions, rights, etc. Mishandling corporate actions in the index may result in artificial jumps or distort index adherence to its definitions. An obvious corporate action that affects the index is the receipt of dividends from a stock and, similarly, interest from a bond. A stock goes ex-dividend, reducing the price by dividend amount. The dividend is later paid as cash. The index may chose to “reinvest” the dividend in the stock by increasing the number of shares. Alternatively, they may ignore the dividend. Split ratios are defined by the corporate action and the share count changes occur after the market close of business on split date. The index may chose to add both parent and child stocks in a spin-off or just keep the parent.

Factors affecting Index Performance

Factor	Key Drivers	Impact Path	Typical Data Points
Constituent Fundamentals	Earnings growth, balance-sheet health, cash flows	Security prices → index level	Quarterly EPS, ROE, leverage ratios
Sector & Style Rotation	Flows into/out of sectors or factors	Weight shifts within index; leaders vs. laggards	Relative sector returns, factor index spreads
Macroeconomic Conditions	GDP growth, inflation, employment	Discount rates & forward earnings expectations	PMI, CPI, payrolls, GDP prints
Monetary & Fiscal Policy	Central-bank rates, QE/QT, government spending	Cost of capital, liquidity backdrop	Fed funds rate, yield-curve shape, fiscal balance
Interest-Rate & Credit Markets	Treasury yields, credit spreads	Equity risk premium, financing costs	10-yr yield, IG & HY OAS
Currency Movements	Home-currency strength/weakness	Multinationals’ earnings translation; EM capital flows	DXY, trade-weighted FX, USD/CNY
Commodity Prices	Oil, metals, agriculture	Input costs for sectors (energy, materials, airlines)	WTI/Brent, copper, gold
Corporate Actions	Buybacks, dividends, M&A	Alters share counts/effective weight; cash returned	Announced programs, ex-date calendars
Liquidity & Market Microstructure	ETF flows, futures roll, option gamma exposure	Short-term volatility, index drift at month/quarter ends	ETF creations/redemptions, VIX term structure
Behavioral & Sentiment	Investor surveys, positioning, media tone	Momentum, overshoot/undershoot from fair value	AAII sentiment, put/call ratios, Google Trends
Exogenous Shocks	Geopolitics, pandemics, natural disasters	Risk-off spikes, sector-specific dislocations	Event headlines, defense-sector gaps

Leveraging an index through ETFs

1. Daily target, daily rebalance – At each market close the fund manager resets exposure to roughly 200 % of that day’s closing index value.

2. Derivatives, not margin loans – Exposure is achieved with swap contracts and futures, keeping the fund fully invested without borrowing cash.

3. Path dependency – Because the fund re-leverages every day, multi-day returns equal 2× only if price changes are monotonic. In volatile sideways markets, the fund can lose value even when the index ends flat (“volatility drag”).

4. Financing cost & fees – Management fee (~0.95 %), swap financing, and transaction costs are baked into performance; there are no margin calls for shareholders, but costs rise with volatility.

Fees that Impact Index Tracking

Fee / cost bucket	Who pays it?	How it’s assessed	Typical range*	What it really covers
Expense ratio (a.k.a. Total Expense Ratio, TER)	All shareholders, pro-rata, via a tiny deduction from NAV each day	Stated as % of assets per year (e.g., 0.03 %)	• Broad-market index ETFs: 0.02–0.10 % • Smart-beta / active: 0.15–0.75 % • Niche themes / leveraged: 0.80–1.00 %+	Wraps together the management fee, index-licensing, custody, audit, admin and marketing (12b-1) expenses.
Management fee	Same	Included in TER (sometimes disclosed separately)	~70-90 % of the TER	Pays the sponsor for portfolio management and keeping the product listed.
Acquired fund fees (for “fund-of-funds” ETFs)	Same	Added on top of sponsor’s fee	0.01–0.15 %	Underlying ETFs’ own expense ratios roll up into the parent fund’s TER.
Transaction costs inside the ETF	Indirect—borne via tracking difference	Embedded in NAV when the AP creates/redeems or when the manager rebalances	Varies with turnover and spreads	Brokerage, FX, and market-impact costs incurred by the portfolio manager. Broad, low-turnover ETFs keep these near zero; high-churn thematic funds don’t.
Bid-ask spread	The investor trading on the exchange	Paid once, when buying and again when selling	Large-cap ETF: 0.01–0.05 % of price Micro-cap / exotic: 0.30 %+	The liquidity premium charged by market makers. Tighter for heavily traded, broad funds.
Brokerage commission	Investor, if broker charges	Flat dollar or per-share	$0 at most U.S. retail brokers; up to $6.95 at some	Going zero at discount brokers, but still present for many institutions and non-U.S. accounts.
Premium/discount to NAV	Investor if they buy above (or sell below) NAV	Market price vs. end-of-day NAV	Usually < 0.10 % for liquid ETFs; can be multi-percent in stressed markets or illiquid asset classes	Reflects primary-market frictions and time-zone gaps (e.g., U.S.-listed China ETFs).
Creation/redemption fees & swing factors	Authorized Participants (APs); indirectly influence retail spreads	Small fixed fee per basket, plus variable cash component	$250–$1,500 per creation unit (50k–100k shares)	Compensate the fund for in-kind securities processing or cash trades; APs bake it into your spread.
Securities-lending revenue split	Negative cost—reduces TER	Offset daily against expenses; split 50-90 % to fund, rest to lending agent	Can shave 0.01–0.05 % off net cost in large-cap equity ETFs	Lending stock to short sellers; good programs meaningfully lower the net expense ratio investors experience.
Tax drag (for non-US domiciles or distributions)	Investor	Withholding taxes, capital-gain distributions, own tax bracket	Highly idiosyncratic	ETF structure minimises but doesn’t eliminate; U.S. equity ETFs rarely pay capital-gain distributions, but dividend taxes still apply.

Conclusion

Indices are fundamental to markets. They help provide a measure for performance that shapes how investors make decisions, particularly related to risk allowances. The establishment of a trusted index is necessary to expand trading into new asset classes. Creating benchmarks for crypto assets is the next step for the space to become sufficiently established.