Definition
An index is a calculated measure of the combined performance of a defined group of securities or other assets, such as a market, sector or asset class. It is a number rather than an investment, and it is built to a published rulebook.
How it works
An index provider sets rules for eligibility, size, liquidity and review dates, then calculates a level from the constituents' prices and a weighting scheme. For a cap-weighted price index, the level is the constituents' combined market value divided by a divisor that is adjusted for membership changes and corporate actions, so the level does not jump when those changes occur.
A price index counts only price changes, while a total return index also adds reinvested dividends, so two versions of the same index grow at different rates. Funds and derivatives can be built to track an index, but an index itself cannot be bought.
Formula / convention
Index level = Sum of constituents' market values ÷ Divisor (cap-weighted price index)
Illustrative example
Illustration with fictional figures: a new index starts at a level of 1,000 when its constituents' combined market value is HK$500 billion, so the divisor is HK$500 billion ÷ 1,000 = HK$0.5 billion per index point. If the combined market value later reaches HK$540 billion with no membership changes, the level is HK$540 billion ÷ HK$0.5 billion = 1,080, a gain of 8%.
What to watch for
An index is not an investment: its return excludes fund costs and trading frictions and, for price indexes, dividends. Rules, constituents and weights change at each review, so an index's history reflects its own construction.