A financial index is a metric that tracks the performance of a specific segment of the market. It is typically composed of multiple individual securities — such as equities, bonds, commodities, or other financial instruments. By bundling a broad range of assets, an index creates an aggregated value that reflects the overall market trend more accurately than any single security. As a result, indices often serve as practical market barometers and provide a clear snapshot of broader market movements.

• Composition: The selection of securities included in an index follows predefined rules. For equity indices, these are typically the largest and most liquid listed companies within a country or sector, measured by market capitalisation. The German benchmark index DAX®, for example, comprises the 40 largest and most liquid publicly traded companies in Germany. Indices, however, are not limited to equities: there are bond indices, commodity indices and many other categories. Examples include the MSCI World as a global equity index, the Bund Rentenindex for German government bonds, or the Bloomberg Commodity Index for commodities. This broad spectrum allows indices to represent virtually any segment of the financial market.
• Function: An index is essentially a statistical measure that tracks the performance of a specific market and compares it with previous periods. If the index rises, it signals price increases in the underlying market segment; if it falls, prices are generally declining. As a result, indices serve investors and economists as an important orientation tool — condensing complex market movements into a single, comprehensible figure.

When analysing indices, you will often come across the terms price index and total return index. Understanding the distinction is essential.

• A price index reflects only the pure price movements of its constituent securities.
• A total return index, by contrast, includes additional income components — typically dividends — which are assumed to be reinvested back into the index.

In practice, this means that a total return index shows the actual overall performance including dividends, while a price index captures only capital gains. For example, the German DAX® is a total return index that reinvests all dividends of its member companies. In contrast, many international benchmarks such as the EURO STOXX 50® or FTSE 100® are commonly quoted as price indices that exclude dividend effects.

This distinction matters greatly: Over longer periods, reinvested dividends can account for a substantial share of total returns. Since the late 1980s, for instance, the DAX® Total Return Index has gained about +2,316 percent, while the DAX® Price Index rose only about +805 percent — meaning that more than half of the long-term return came from dividends. Investors should therefore always check whether dividends are included to ensure a realistic comparison of index performance.

How is an index calculated? In addition to the selection of index constituents, the weighting method plays a crucial role. Most well-known equity indices are weighted by market capitalization: larger companies carry a higher weight in the index. As a result, price moves in heavyweights have a much stronger impact on the index than moves in smaller constituents. For example, in the DAX® or S&P 500®, the most valuable companies account for a substantial share of the index. If a giant such as Apple or SAP rises or falls sharply, it moves the entire index noticeably – while a price change in a small constituent barely registers.

This market-cap-weighted approach has a drawback: concentration risk. As the weight of individual stocks grows, the risk increases that the index becomes dominated by a small number of names. In the United States, this effect is particularly pronounced: At times, more than 30 percent of the S&P 500® has been concentrated in just a handful of large technology stocks (the so-called "FAANGM" group). A similar picture emerges in the global MSCI World Index, where roughly seventy-four percent of the index is invested in the United States – with around twenty-four percent alone in seven major US technology companies. Although such indices contain hundreds of stocks, a significant share of performance ultimately depends on the fortunes of a few large companies. This can lead to above-average gains in boom phases, but it also increases the risk of sharp drawdowns if market leaders lose momentum.

Equal-weighted indices offer an alternative construction to address this concentration issue. Under an equal-weight approach, all constituents receive the same weight, regardless of their size. This means each stock has a similar influence on index performance. The S&P 500® Equal Weight Index, for example, includes the same 500 stocks as the standard S&P 500®, but allocates roughly 0.2 percent to each company instead of weighting by market capitalization. The impact is substantial: in the standard version, the top ten names account for around 35 percent of the index; in the equal-weighted version, they sum to only about 3 percent. Equal-weight indices benefit less from the extreme rallies of individual heavyweights, but in return they help avoid one-sided concentration risks caused by overvalued mega caps. They must be rebalanced regularly, as price movements naturally create imbalances over time – typically this happens on a quarterly basis. For investors, alternative weighting schemes such as equal weight can therefore provide broader risk diversification within an index.

Financial indices serve several essential functions in the investment world. First, they act as benchmarks — reference points for evaluating the performance of investment portfolios. Institutional investors such as fund managers and asset allocators rely on indices to assess whether their strategies are generating added value. If a fund outperforms its benchmark, it is considered an outperformer; if it lags behind, it is viewed as underperforming. Indices therefore set the standard against which active management is measured and also provide quick insights in the financial media as indicators for the broader market environment.

Second, indices form the basis for a wide range of investment products. This includes derivatives such as index futures and options, which investors use to hedge or express directional views. Even more relevant for most investors are index funds — particularly ETFs. These exchange-traded funds replicate an index one-to-one, enabling investors to gain exposure to all index constituents with a single investment. Because investors cannot buy an index directly, ETFs are the most common way to participate in its performance. For example, an ETF on the MSCI World automatically diversifies capital across roughly 1,600 global equities, offering broad market exposure at relatively low cost. The fund’s performance closely mirrors that of the underlying index.

However, investors should be aware that an ETF inherits both the strengths and the weaknesses of its benchmark. While it benefits from broad diversification, it also fully reflects any concentration risks or structural imbalances embedded in the index. An index has no active risk management — it mirrors market structure as it is, regardless of whether that structure appears robust or distorted. This applies to equity indices just as much as to bond indices.

• Advantages: One of the strongest arguments in favor of financial indices is diversification. By pooling many individual securities, they reduce the specific risk of single holdings. An index investment automatically spreads capital across different companies, sectors, or countries, lowering concentration risk compared with investing in a single stock. For long-term investors in particular, broadly diversified indices provide a solid foundation, helping smooth out the volatility of individual names. Indices are also transparent — their calculation follows predefined rules, and their composition is publicly available. This creates clarity and comparability. Finally, index-based products such as ETFs are cost-efficient and highly liquid, making it easier for investors to access capital markets.
• Risks: However, investors should not assume that an index automatically delivers perfect diversification. As outlined above, traditional market-cap-weighted indices can exhibit significant concentration risks. When a handful of heavyweights dominate an index, much of the intended diversification can diminish. A supposedly broad market exposure may, in reality, depend heavily on the performance of just a few large companies or sectors. In the worst case, this can alter the index’s underlying risk-return profile — for example, when rapidly rising technology stocks gain outsized weights and drive volatility higher. Historical episodes such as the dot-com bubble around the year 2000 demonstrate how excessive concentration in a few market darlings can ultimately lead to sharp corrections. Anyone investing in indices should therefore always look under the hood: How is the index capital allocated? Are there dominant positions?

This principle applies not only to equity indices but to bond indices as well. Here, another paradoxical effect emerges: debt-weight concentration. Traditional bond benchmarks weight issuers by the amount of outstanding debt — meaning the most heavily indebted countries or companies receive the largest index weight. A sovereign bond index, for example, allocates the most capital to countries with the highest debt levels, while a corporate bond index heavily favors issuers that have sold large volumes of bonds. Yet high indebtedness often comes with greater default risk. Passive bond ETFs must follow this structure and are required to hold proportionally large positions in potentially problematic issuers. For example, Greece was still heavily represented in major euro government bond indices shortly before its sovereign debt crisis — even though many active funds had already significantly reduced exposure. This highlights a key point: index replication has no built-in warning system. As long as an issuer remains part of the index, it stays in the portfolio. Concentration risks can therefore grow unnoticed.

A financial index is an essential tool for navigating the investment landscape — it provides quick orientation, enables broad diversification, and serves as a neutral barometer for market trends. For investors, indices offer a simple way to participate in the performance of entire markets with minimal effort. However, it is important not to overlook their limitations. A financial index represents a bundle of market values that reflects overall market performance and allows broad participation. At the same time, it is not a self-managing solution: investors should not follow an index blindly but instead understand how it is constructed and remain mindful of potential concentration risks. When applied with this awareness, a financial index — whether used as a benchmark or as an investment vehicle — can be a highly effective component of a long-term investment strategy without turning into a hidden pitfall.