What it means
An index is a list of securities combined into a single number that rises and falls with their prices. Index providers choose which countries and companies to include, based on rules about size, trading volume and how easy it is for foreigners to invest.
The result is a yardstick for the market. Most emerging markets indices are weighted by market capitalisation, which means that larger companies have a bigger effect on the index.
Many also adjust for free float, counting only the shares that are available for the public to buy. This keeps the index closer to what investors can actually own.
Indices are used in two main ways. Analysts and journalists use them to describe how emerging markets are performing, and fund managers use them as benchmarks.
A manager who earns less than the index after fees has not added value, while one who beats it has. The index also decides what passive funds buy.
When a company is added or removed, or when a country changes status, funds that track the index must buy or sell, which can move prices. Investors should therefore understand the rules for country and company weights.
A nuance is that different providers define emerging markets differently, so two indices may include different countries and have different weights. Some are dominated by a few large countries or technology firms, which affects how diversified they really are.
Always check the factsheet, which lists the top countries and companies. Investors should also bear in mind how rebalancing works.
Index providers review membership once or twice a year, and companies can be added, removed or have their weights changed. These events can cause large trades on specific days, which is why passive funds sometimes show small differences from the index they follow.
In practice
Real-world examples.
Example
A fund manager compares her portfolio's 12% return with a 9% return on the emerging markets index. She tells clients that she outperformed the benchmark by 3 percentage points. She reminds them that the comparison is only useful if the benchmark matches the fund's real investment universe.
Example
An exchange-traded fund company launches a product that tracks an emerging markets index. Investors can buy one share to own a slice of hundreds of companies. Buyers pay a small annual fee, and the fund tries to keep its returns very close to the index.
Example
A news report says that the index fell 4% in a week after a currency shock in one country. An investor checks the weights and sees that the country makes up a quarter of the index, which explains the impact. He decides to review his overall holdings so that no single country dominates his savings.
Formula
Calculation
Weight of a company = company market value / total market value of all companies in the index.
Worked example: a simplified index holds three companies with market values of $300 billion, $200 billion and $100 billion.
1. Total market value = $300 billion + $200 billion + $100 billion = $600 billion
2. Weights: $300 / $600 = 50%, $200 / $600 = 33.3%, $100 / $600 = 16.7%
3. A passive fund of $1,200,000 following this index would hold $600,000, $400,000 and $200,000 respectively
If the first company's value rose by 10% and the others were unchanged, the index would rise by 50% x 10% = 5%.Case study
Seen in the real world.
Crestline Asset Management is an illustrative, fictional firm that ran an actively managed emerging market fund. Clients complained that returns were lower than the index and asked why they should pay higher fees.
The firm analysed its performance against the benchmark. It found that it had outperformed in stock selection but lost ground because it held less in a few very large companies that had performed well.
The firm explained this to clients and reviewed its approach to large holdings. It also began to publish a quarterly comparison with the index. The illustrative lesson is that the index sets the standard against which skill and cost are judged, and understanding its makeup is vital. The manager's reports now also include a table of the five largest index holdings and the fund's position in each, so that clients can see exactly where the differences arise.
Watch out
Common mistakes.
- Assuming an emerging markets index is evenly spread across countries, when a few countries or companies often dominate.
- Comparing a fund with a poorly matched benchmark.
- Treating index returns as what an investor receives, when fees, taxes and currency effects also apply.
Questions
People also ask.
What is an emerging markets index used for?
It measures how emerging markets are performing and serves as a benchmark for funds.
How are companies weighted?
Most indices weight them by market capitalisation, often adjusted for the shares that are freely available to trade.
Can I invest in the index directly?
Not directly, but you can buy index funds or exchange-traded funds that aim to follow it.
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