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The ETF Book: All You Need to Know About Exchange-Traded Funds, Updated Edition by Richard A. Ferri

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CHAPTER 6

Benchmark Indexes and Strategy Indexes

Most exchange-traded funds (ETFs) attempt to track the performance of indexes. Accordingly, knowing how those indexes are constructed and maintained is an important part of ETF analysis. Understanding how index providers select securities and weight those securities in an index gives you deep insight into how an ETF is managed, and this puts you in a much better position to make a prudent investment decision.

There is no lack of indexes available for licensing by ETF companies. Several hundred thousand securities are traded worldwide, and they can be arranged and weighted in an infinite number of ways to create different index types. A detailed study of each index method would be overwhelming if not impossible because more new indexes are being created every day. But there are ways to sort and classify indexes based on their basic construction methods. The next few chapters will give you the basic tools needed to do this index analysis so that you have meaningful information upon which to base your index ETF selections.

There are two basic types of indexes: benchmark indexes and strategy indexes. A benchmark index is a measurement tool that at its core has the intent to measure the total value of a financial market or a segment of a market. In contrast, a strategy index is an alternative investment approach to investing in a market.

Benchmark index–based ETFs and strategy index–based ETFs form two different types of investment products. ...

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