What Is Indexing?
Let me explain indexing to you directly: it's basically using a benchmark indicator or measure as a reference point. In finance and economics, I see it as a statistical tool for tracking things like inflation, unemployment, GDP growth, productivity, and market returns.
You might also hear indexing in the context of passive investment strategies that copy benchmark indexes. This approach has gained a lot of traction over the past few decades.
Key Takeaways
Here's what you need to know: indexing involves compiling economic data into a single metric or comparing data against it. There are numerous indexes in finance that reflect economic or market activity. In economics, these can directly affect people's lives, such as through cost-of-living adjustments linked to inflation. In investing, indexes act as benchmarks for measuring portfolios and fund managers. Finally, indexing often means passively investing in market indexes to match broad market returns instead of picking individual stocks.
Understanding Indexing
In the financial markets, indexing serves as a statistical measure for tracking economic data. Economists create indexes that give us leading indicators of economic trends. You should pay attention to ones like the Purchasing Managers' Index (PMI), the Institute for Supply Management’s Manufacturing Index (ISM), and the Composite Index of Leading Economic Indicators—these track changes over time.
Statistical indexes also link values, like the cost-of-living adjustment (COLA), which comes from analyzing the Consumer Price Index (CPI) to index prices to inflation. Many pension plans and insurance policies use COLA and CPI for adjusting retirement benefits, relying on inflation-based indexing.
Indexing in Financial Markets
An index tracks the performance of a group of assets in a standardized way. These typically measure a basket of securities to replicate a specific market area.
You have broad-based indexes like the S&P 500 or Dow Jones Industrial Average (DJIA) that capture the whole market. There are also specialized ones for particular industries or segments. The DJIA is price-weighted, giving more weight to higher-priced stocks, while the S&P 500 is market capitalization-weighted, favoring larger companies.
Index providers use various methods to build these. Investors and participants use them as performance benchmarks—if a fund manager underperforms the S&P 500 long-term, it's tough to attract investors. Indexes also cover bond markets, commodities, and derivatives.
Indexing and Passive Investing
In the investment world, indexing is known as a passive strategy to gain exposure to a market segment. Most active managers don't consistently beat index benchmarks, and targeting a market segment can be costly due to trading individual securities. That's why indexing appeals to many investors.
You can match a target index's risk and return by investing in an index fund. These funds have low expense ratios and fit well in passive portfolios. They might use individual stocks and bonds or be structured as funds of funds with mutual funds or ETFs.
Most brokerages offer index funds benchmarked to major stock indexes, available as mutual funds or ETFs. Since it's passive, these funds have lower fees and expense ratios than active ones. The simplicity means modest fees, and they're more tax-efficient with fewer trades.
Indexing and Tracker Funds
More advanced indexing strategies replicate customized indexes. Customized tracker funds provide low-cost options for screened securities, using filters like fundamentals, dividends, or growth characteristics.
These funds aim to select the best within a category—for instance, pulling top energy companies from broader energy indexes.
How Is Indexing Used In Investing?
In investing, indexing is a passive strategy where you build a portfolio to track a market index like the S&P 500, aiming to mimic its performance. It offers broad diversification and lower expenses than active management.
What Is a Broad Market Index?
A broad market index tracks a large group of stocks representing the entire market, adding significant diversification to your portfolio. Examples include the S&P 500 and Russell 3000.
Is Indexing a Smart Way to Invest?
Indexing works well for many as it creates a diversified portfolio with lower fees than active funds, mimicking the broader market which often outperforms individual stock picking over time.
The Bottom Line
Indexing means compiling economic data into a single metric or comparing data to measure changes. In economics, various indexes summarize activity, like inflation-linked Social Security adjustments. In investing, they're benchmarks for performance, or a passive strategy to replicate market returns rather than selecting stocks.
Other articles for you
A trend represents the general direction of a market or asset's price movement.
The Relative Strength Index (RSI) is a momentum oscillator used in technical analysis to measure price changes and identify overbought or oversold conditions in securities.
A hierarchical deterministic wallet generates and manages cryptocurrency keys from a single seed for enhanced security and convenience.
Normative economics focuses on value-based judgments about what economic outcomes ought to be, unlike positive economics which describes what is.
A pledged asset is collateral used to secure a loan, allowing borrowers to reduce down payments and interest rates while retaining ownership.
Lehman Brothers was a major investment bank that collapsed in 2008 due to the subprime mortgage crisis, marking the largest bankruptcy ever.
Realized gains are profits from selling assets above purchase price, creating taxable events, unlike unrealized paper gains.
The Wilcoxon test is a nonparametric statistical method for comparing paired data to detect significant differences without assuming normal distribution.
A market-neutral strategy profits from both rising and falling prices while minimizing overall market risk through balanced long and short positions.
Inventory accounting involves valuing and tracking changes in a company's inventoried assets across production stages to ensure accurate financial representation.