Definition of index

An indicator of trends in a market or economy, reflecting changes in various component data (often weighted to account for their relative importance).

An index is a portfolio of stocks, chosen according to simple, pre-defined rules, and designed to capture a particular investment style.  It is a performance benchmark, in as much as it represents an achievable return from a largely passive investment strategy. These rules don’t add any insight into the merits of the underlying constituents of the index but help in its construction. 

Indices have become central to the fund management industry. This is because portfolio managers not only require an appropriate benchmark but clients require it as well. In effect, an index helps deliver an independent rate of return and as a benchmark forms an objective test of the effective implementation of an investment strategy. 

The key trade offs any index has to balance are breadth versus how investable it is; rebalancing versus turnover costs; and rules versus sampling value judgements.

The first equity index is largely attributed to Charles Dow in 1884, who created the Dow industrial average in 1886.   The FT-Actuaries Share Index was first published in 1962. More recently, the  Capital Asset Pricing Model, the most widely taught asset pricing model, has provided a framework for index constructors.  It took the construction of indexes away from just mathematical calculation and sampling technique to a more scientific level. [1]