The terms “index” and “benchmark” are often used synonymously, which can understandably confuse investors. In simple terms, in the world of investing, a benchmark is a standard point of reference against which the performance of an investment can be measured. When benchmarking the performance of an investment, an index—a hypothetical portfolio of stocks designed to represent the relative asset class, market or market segment—is typically used.
Institutional investors such as pension plans, as long-term investors, seek to meet their investment objectives through a variety of investment methods, and the use of indexes throughout this process extends beyond simply benchmarking the performance of the investment portfolio. This guide provides trustees with an introduction to the various purposes indexes can serve and shares some of the important attributes one should consider when selecting an index.
This guide is organized as follows: first, we discuss how important it is for those responsible for institutional investment plans to select appropriate indexes throughout the entire investment process. We share a list of steps, from setting initial plan objectives to performance attribution and reporting, and provide explanations of how indexes are used along each step. Second, we delve into the use of indexes as the basis for investment products, outlining the reasons why some market participants might choose this form of investing over actively managed options to target the same market or market segment, and identifying important considerations for selecting an index as the basis of a product. Finally, we touch on the newest era of indexing—what many refer to as “smart beta”— and discuss the different purposes these types of indexes serve.
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