An index fund of ETF can only be as good as the index it tracks. While these benchmarks are usually transparent and rules-based, they are not all equal. Nuances in construction can cause performance to diverge between seemingly similar index strategies. Sorting out these details is cumbersome. And in a market where thousands of index products line the shelves, distinguishing the good from the bad can be a daunting task.

Morningstar analysts compiled a simple checklist of six characteristics to consider when evaluating index funds. This checklist is foundational to Morningstar Medalist Ratings for index strategies and can point investors toward the best options available. The six traits of the best indexes are:

  • Representative
  • Diversified
  • Investable
  • Transparent
  • Sensible
  • Low Turnover

Is it representative?

The main advantage of index funds is their low cost. Index funds that draw on the full range of opportunities available to their active peers can turn that cost advantage into a bona fide performance edge. In other words, index funds bundle the same stocks and bonds as their active peers and sell them to investors for a lower price. If an index features a different set of securities than the funds it aims to beat, there’s no guarantee its lower fee will matter.

Is it diversified?

The case for diversifying across a wide array of holdings is twofold: 1) The demise of one holding won’t torpedo the performance of the entire portfolio, and 2) casting a wide net improves the chances of catching the next winner to rise from obscurity to market leader.

The best indexes diversify away other sources of risk that the market does not reward. For instance, research shows that loading up in a single sector yields no long-term performance edge. Indexes that reflect the market’s sector composition, rather than concentrate in a select few, position themselves for stronger risk-adjusted performance over the long haul.

Is it investable?

Indexes that invest in illiquid securities can be hard to track or have limited capacity, meaning that they are not practically investable for portfolio managers. Bank loans, for example, trade infrequently and therefore command steep transaction costs, a friction that rubs on bottom-line returns for index strategies. Capacity problems arise when so much money is tied to a benchmark that the prices of its securities move when index funds buy or sell, forcing them to execute at unfavorable prices.

Indexes operating in illiquid market segments may choose to impose liquidity thresholds to address investability concerns. However, this may eliminate a significant chunk of the opportunity set, hurting the index’s representative trait.

Is it transparent?

A clearly defined index allows investors to anticipate its behavior across market environments, ensuring that investors are getting what they expect. Most benchmarks check this box.

That said, indexes that are curated by investment committees rather than hard-and-fast rules don’t meet the transparency standard. The S&P 500 is the most notable example. The same goes for index funds that rely on an optimizer to generate their portfolios.

Is it sensible?

Sensible indexes answer yes to the question: “Are the rules that govern this portfolio’s construction driven by sound economic rationale?” Most index funds meet this standard. But a couple that do not meet it happen to be some of the most popular.

Consider BetaShares NASDAQ 100 ETF (ASX: NDQ). It tracks the Nasdaq-100 Index, which admits only companies whose primary listing is the Nasdaq exchange. That requirement has no economic basis: It’s the result of Nasdaq promoting its exchange, and it strips out prominent stocks listed on other major stock exchanges, like Eli Lilly, Home Depot, and Salesforce.

Likewise, we can look at the oft quoted Dow Jones Industrial Average—a relic of the 1800s. It only holds 30 stocks, and they are weighted by price not market cap, which makes no economic sense.

Is it low-turnover?

Finally, good indexes take strides to dial back undue portfolio turnover. Trading securities isn’t free, and the costs can pile up quickly in illiquid markets. For example, indexes may implement buffers around their upper or lower market-cap bounds to limit turnover dictated by short-term performance, within reason. Those that do not have buffers felt the sting of higher turnover over the years.