Index investing through exchange-traded funds (ETFs) is booming. Indexed assets already exceed 10 percent of the value of the U.S. equity market and by the end of 2008, there may likely be over 1,500 index products available. Unfortunately, investors and advisors have become overwhelmed with different index options available. It is difficult at best to keep up with the new products that follow the new indexing strategies.

Gone are the days when indexes existed solely to measure market value. Today, many new indexes are highly customized investment strategies that are designed to be investment products rather than market indicators. These index strategies are often complex, and categorizing them has moved beyond standard-style classification methods such as Morningstar Style Boxes™. What was needed, and what this paper explains, is a complementary classification system that differentiates indexing methodologies based on their published rules for security selection and security weighting.

The index categorization methodology briefly introduced in this paper is a new way to look at the marketplace. The classification method has two stages. The first step defines the purpose of an index, and the second defines the index strategy using a new tool called Index Strategy Boxes™. Incorporating these two stages will greatly reduce the time needed to analyze index-based products by quickly identifying how an index is constructed and maintained.

Market Indexes and Custom Indexes
The first step in the analysis is separating indexes by purpose. There is a significant difference between traditional market indexes and highly customized strategy indexes.

Market indexes are market measurement tools. Their primary purpose is to measure the general price level and value of financial markets and segments of those markets. Constituents in a market index are commonly selected using passive methods, and they are capitalization weighted. Market indexes have always been important financial indicators as global valuation yardsticks. They are reviewed and analyzed at the highest levels of economic analysis, including all central banks. In addition, market indexes are the basis for asset allocation decisions, whether those decisions are being made by individual investors or institutions. Finally, market indexes are the benchmark against which all active investments strategies are measured.

Many new indexes are highly customized investment strategies that are far from market measurement tools. In fact, these indexes are intentionally designed not to mirror the price action and performance of market indexes. The creation of strategy indexes are primarily driven by the needs of the product manufacturers. Basically, custom strategy indexes are licensed to investment companies and launched as innovative investment products that compete against market index products. It is worth noting that products following custom index strategies generally have higher fees than products that follow market indexes.

Index Strategy Boxes
The rules for the construction and maintenance of any index are published by the index provider and are available to the public. Typically the index methodology can be found in a handbook located on the index provider’s website. However, it is worth noting that some index providers offer more transparency than others, and some only provide the bare minimum as required by the Securities and Exchange Commission (SEC).

Index Strategy Boxes™ categorize published rules and add order to the marketplace. That helps investors visualize how an index is "managed" and allows them to anticipate what should be taking place in the funds they are analyzing. The classification method focuses on two rule types: security selection methodology and security weighting methodology. All indexes have set rules for security selection and set rules for weighing the securities that are selected. Those two rules' axis applies to indexes including stocks, bonds, commodities and currencies.

Index Strategy Boxes™ divide funds by three primary types of security selection and three primary types of security weighting. The two dimensions can be illustrated on vertical and horizontal axes, which form nine Index Strategy Boxes™. Figure 1 illustrates the tic-tac-toe design of Index Strategy Boxes™. Every index falls into one of the boxes.

Figure 1

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