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Lesson 5 of 10 · 11 min
Index objectives, custom indexes and choosing a version
An index is a benchmark and a blueprint for passive funds, built in five steps from a stated objective; custom indexes bend the rules toward a target, and the right version (price or total return) and weighting depend on what the index is used for.
In short
- Indexes are indicators, benchmarks and the blueprint that index funds and ETFs copy. Passive investing replicates an index at low cost; active investing tries to beat one.
- Custom indexes screen and weight constituents toward a goal: factor (value, momentum), thematic, income-oriented, risk-weighted (e.g. minimum variance) and active-strategy indexes.
- Five steps: objective → constituent selection → weighting → calculation (start date and value) → maintenance (rebalancing, reconstitution, corporate actions, rule reviews).
- Use a price return index for non-dividend payers, short-term trends and strategies that do not reinvest income; use a total return index for dividend payers, long horizons, mutual funds and dividend reinvestment plans.
- Market-cap weighting brings concentration risk in the largest firms; equal weighting spreads influence but can tilt toward sectors; fundamental weighting suits value-oriented investors and leaves out firms without the chosen metric.
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