Charles Dow created the first index in 1896. Since then, creating and providing indices has become a big business - and a fiercely competitive one at that. From being mere information providers today, indices such as the Dow Jones Industrial Average and the S&P 500, FTSE 100, MSCI, NIFTY and SENSEX are among the best-known brands in financial markets. Index providers determine whether the fund performance has been good – because beating the benchmark is the single most important aspect of asset management. Critically, index providers are the most influential players in equity markets, as they drive asset allocation decisions through their index inclusions and exclusions. For active funds, indices represent a benchmark that fund managers need to beat. For passive funds, index constituents form the investible universe, and index funds mirror the index components in scrips and weights. Then there are the index-based derivatives, for which the index itself is the underlying asset.

Indices need to be both representative of the overall market, and replicable, especially for passive funds. Indices are created after considering quantitative factors such as market capitalization, free float, impact cost, F&O constituents. Index providers also maintain an issuer universe, solely from which securities can enter the index. For example, in the NIFTY 500, securities will be only included if their rank based on full market cap is among top 350 and full market cap is 1.5 times the full market cap of the smallest constituent, while securities will be excluded if their rank based on full market cap or average turnover falls below 800.

With the increased awareness around ESG, index providers have created indices based on the Environment, Social and Governance pillars. Globally, the first ESG index was launched in 1990, today there are at least 1,000 ESG indices, stressing the demand around ESG products. These ESG indices play a crucial role in benchmarking against ESG funds and give investors a chance to invest in a pool of securities with the best ESG practices or at least a greater focus on this aspect. ESG indices, like the MSCI India ESG Leaders Index, aim to incorporate companies with the highest ESG ratings and adjust target sectors and weights to limit the systemic risk introduced by the selection process. ESG Indices also play a crucial role in prevention of greenwashing.

One of the enduring debates is whether equity indices reflect the country’s GDP. After all, the equity markets themselves are considered a barometer of economic well-being. Index providers believe that for their main indices to be reflective of the state of the economy, the capital markets need to have greater penetration and more companies need to be listed. Therefore, for India, the main indices will not be a barometer of the country’s economic health – only a reflection of its equity markets.

Index construction methodologies are largely driven by quantitative data points. For investors that need to factor in regulations, exposure caps and several other structural constraints to help manage risk, these indices may not always be perfectly replicable. To discuss some of these challenges, NSE and IiAS jointly held a CIO Dialogue with Index Providers.

The key takeaways from this dialogue are available in our report here