What Is an Index?

An index is a numerical representation of asset prices, used to measure the performance of a group of assets in a standardized manner. It typically evaluates the performance of a basket of securities aimed at mimicking a specific market area.

There are different types of indexes: broad-based ones covering the entire market like the S&P 500 and Dow Jones Industrial Average, and specialized ones focusing on specific industries like the Russell 2000, which tracks small-cap stocks.

Key Takeaways

• An index measures the price performance of a group of securities using a standardized method.
• Indexes are often benchmarks used to assess an investment’s performance.
• Significant U.S. indexes include the S&P 500 and Dow Jones Industrial Average.
• Passive index investing is a popular low-cost way to mirror the returns of major indexes.
• Benchmarking against the appropriate index is crucial for understanding portfolio performance.

Investopedia / Mira Norian

Understanding Indexes

Indexes are also used to gauge financial and economic data such as interest rates, inflation, or manufacturing output. They serve as benchmarks to evaluate portfolio returns. Indexing, a popular strategy, aims to replicate an index passively instead of trying to outperform it.

In finance, indexes track changes in security prices and reflect market performance. Stock and bond market indexes consist of hypothetical portfolios representing specific markets. Popular indexes are the S&P 500 and Bloomberg US Aggregate Bond Index.

Each stock and bond index has its calculation method, with the relative change being more crucial than the actual numeric value. For instance, the FTSE 100 Index at 6,670.40 indicates a sevenfold increase from the base level of 1,000.

Index Investing

Indexes are utilized as benchmarks to evaluate mutual funds and ETF performance. Many mutual funds compare returns with indexes like the S&P 500 to show investors how managers perform against index funds.

Indexing is a form of passive fund management whereby fund managers construct portfolios mirroring particular indexes to match their performance. Popular index funds, like the Vanguard S&P 500 ETF, closely mimic major indexes like the S&P 500.

Index funds are created to track index performance, allowing investors to invest in securities mirroring an index’s composition for a fee. Fund sponsors design mutual funds and ETFs mirroring specific indexes for investors to align with the market’s performance.

Index Examples

Popular indexes include the S&P 500, representing 80% of U.S. traded stocks, and the Dow Jones Industrial Average, reflecting values of 30 publicly traded companies. Other notable indexes are Nasdaq 100, Wilshire 5000, MSCI EAFE, and Bloomberg US Aggregate Bond Index.

Indexed annuities follow a trading index, offering returns tied to the index but typically capped. Adjustable-rate mortgages base interest rates on indexes like the London Inter-bank Offer Rate.

What Is an Index Fund?

An index fund is a passive mutual fund or ETF mirroring an index’s performance without active management. This strategy tends to outperform active stock selection, with lower fees and tax exposure.

What Are Different Ways to Construct an Index?

Indexes can be constructed in various ways, such as market-cap weighting, price-weighted, or equal-weighted.

• Market-cap weighting emphasizes components with greater market capitalization, like S&P 500.
• Price-weighted indexes focus on components with higher prices, as seen in Dow Jones.
• Equal-weighted indexes allocate equal weights to all components.

Why Are Indexes Useful?

Indexes offer benchmarks to measure investment performance against a strategy or portfolio, aiding in understanding true performance. They also provide a snapshot of market sectors without analyzing individual assets.

What Are Some Major Stock Indexes?

In the U.S., primary stock indexes include Dow Jones Industrial Average, S&P 500, Nasdaq Composite, and Russell 2000. Internationally, indexes like FTSE 100 and Nikkei 225 represent British and Japanese markets.

What Are Some Bond Indexes?

Besides stock indexes, bond indexes like Bloomberg Aggregate Bond Index and Emerging Market Bond Index monitor bond market performance.

The Bottom Line

Market indexes offer a comprehensive view of market performance, serving as benchmarks for market segment movements. Investors use indexes for portfolio and passive index investments, focusing on key indexes like S&P 500 and Nasdaq 100 in the U.S.