In most cases, investors choose a market index, or combination of indexes, to serve as the portfolio benchmark. An index tracks the performance of a broad asset class, such as all listed stocks, or a narrower slice of the market, such as technology company stocks. Because indexes track returns on a buy-and-hold basis and make no attempt to determine which securities are the most attractive, they represent a “passive” investment approach and can provide a good benchmark against which to compare the performance of a portfolio that is actively managed. Using an index, it is possible to see how much value an active manager adds and from where, or through what investments, that value comes.

These are among the most widely followed stock indexes, or benchmarks:

Fixed income securities do not trade on open exchanges, and bond prices are therefore less transparent. As a result, the most commonly used indexes are those created by large broker-dealers that buy and sell bonds, including Barclays Capital (which now also manages the indexes originally created by Lehman Brothers), Citigroup, J.P. Morgan, and BofA Merrill Lynch. Widely known indexes include the Barclays U.S. Aggregate Bond Index, tracking the largest bond issuers in the U.S., and the Barclays Global Aggregate Bond Index of the largest bond issuers globally.

Actually, bond firms have created dozens of indexes, providing a benchmark for virtually any bond market exposure an investor might want. Barclays Capital alone publishes more than 30 different bond indexes. New indexes are often created as investor interest grows in different types of portfolios. For example, as investor demand for emerging market debt grew, J.P. Morgan created its Emerging Markets Bond Index in 1992 to provide a benchmark for emerging market portfolios.

Indexes also exist for other asset classes, including real estate and commodities, and these may be of particular interest to investors concerned about inflation. A couple of examples are the Dow Jones U.S. Select Real Estate Investment Trust (REIT) Index and the Dow Jones-UBS Commodity Index.

Index Methodologies: Market Capitalization and Alternatives

The major index providers use specific, predetermined criteria, such as size and credit ratings, to determine which securities are included in a particular index. Index methodologies, returns and other statistics are usually available through the index publisher’s website or through news services such as Bloomberg or Reuters.

Instead of averaging stock or bond prices, indexes typically weight each component; the most common weighting is based on market capitalization. Companies with more equity or debt outstanding receive higher weightings and therefore have greater influence on index performance. Big price swings in the stocks or bonds of the largest companies can create big price movements in an index.

To reduce the volatility that may result with market cap weighting and potentially improve performance, alternative indexing methodologies have emerged in recent years. Among these, fundamental indexing, developed by PIMCO subadviser Rob Arnott and Research Affiliates, selects and weights components using fundamentals such as sales, cash flow, book value and dividends.

Bond indexes using market cap weighting can have a troubling twist: The most influential components may also have the biggest debt loads, which can be a sign of deteriorating finances. In part to avoid overexposure to highly indebted countries and companies, PIMCO introduced a bond index in 2009 based on gross domestic product, called the PIMCO Global Advantage Bond Index (GLADI)TM, which attempts to identify investment opportunities in fast-growing economies. GLADI also includes more instruments than a typical bond index, such as swaps and inflation-linked bonds. Markit LLC, an independent and unaffiliated leading financial information services company and global index provider, administers and calculates the GLADI index.

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