Indexing is a passive investment strategy where you construct a portfolio to track the performance of a market index. It is commonly done with the S&P 500 Index, where investors try to mimic the performance of the index.
Indexing also refers to metrics used to gauge the performance of an economic activity. For example, the Consumer Price Index (CPI) is used to estimate the purchasing power of the US dollar. The CPI is also used to measure the rate of inflation.
The S&P 500 Index and the Dow Jones Industrial Average (DJIA) are used to track the performance of the US equity market. The NASDAQ Composite Index tracks the performance of large companies in order to predict major economic trends.
Uses of Indexing
There are two main uses of indexing in financial markets. They include:
1. As a Gauge for linking values
The Consumer Price Index (CPI) provides a basis for calculating the cost of living adjustment (COLA), designed to reflect the current cost of living based on changes in prices of consumer goods and services. Pension plans also rely on the CPI to adjust retirement benefits.
The CPI tracks the changes in the prices of consumer goods and services in a specific location. Apart from calculating the annual COLA and retirement benefit payouts, the CPI is also used to adjust salaries and interest rates.
2. As Indicators of economic trends
Indexes or indices can also be used as indicators of economic trends. For example, an index that tracks the performance of large, publicly traded companies may give indications of future economic growth. Examples of such economic indices include the Index of Leading Economic Indicators – LEI, the Purchasing Managers’ Index – PMI, the Labor Market Index – LMI, and the GDP deflator index. Indexes can provide an overview of current economic trends, as well as clues to possible future trends.
For example, if the LEI reading is increasingly positive for three or four months in a row during a time when the economy has been in recession, this is typically interpreted as signaling an impending economic trend change to a period of strong growth. The LEI figures are released on the third Thursday of each month.
Indexes in the Investment Market
Two of the world’s best-known investment indices are the Standard & Poor’s 500 (S&P 500) and the Dow Jones Industrial Average (DJIA). These indices are discussed in detail below:
The S&P 500 comprises about 70% of all the stocks traded in the United States, and it is one of the most popular benchmarks for measuring the performance of the stock market. It is based on the market capitalization of 500 publicly traded companies.
Unlike many other indices, the S&P 500 uses a market capitalization-weighted methodology and is comprised of a very diverse list of stocks. The index’s components are determined by a committee that evaluates stocks for listing based on their liquidity, public float, sector classification, market capitalization, financial viability, and other factors.
Dow Jones Industrial Average (DJIA)
The Dow Jones Industrial Average (DJIA) measures the stocks of 30 of the largest publicly traded companies in the US. The companies must be listed either on the NYSE or NASDAQ. The DJIA uses a price-weighted methodology, such that high-priced stocks are given greater weight than low-priced stocks. Originally, the stocks that made up the DJIA index were all large industrial firms – hence the name. However, this is no longer the case, as many non-industrial firms have become more significant bellwhethers of the overall equity market.
The DJIA stocks are selected by editors of The Wall Street Journal. If one of the listed publicly traded companies experiences financial difficulties or its performance declines, the composition of the index will change.
What is Index Investing?
Index investing refers to a strategy used to generate returns that are similar to a specific market index. Investors achieve this goal by replicating specific indices such as a fixed income or equity index. One means of index investing is to purchase shares of exchange-traded funds that track an underlying benchmark index.
Index investing is a passive form of investing, which usually results in relatively lower management fees and expense ratios. This is due to the fact that the holdings in an index investing portfolio do not change frequently. Therefore, the fund or portfolio does not incur heavy transaction costs.
Active Investing vs. Passive Investing
In active investing, portfolio managers use their skills to try to outperform the overall market average. They typically seek to identify stocks with high, long-term growth potential. Active investing usually means higher management fees and transaction costs, as the portfolio’s holdings are likely to change much more frequently than is the case with a passive investing strategy. An active approach can be affected by the uncertainties in the market and the biases of the manager.
The holdings of actively managed portfolios may be more diverse than index-based portfolios. The portfolio manager may invest in domestic stocks, international stocks, and other asset classes besides equities. For example, part of the holdings of an actively managed portfolio may consist of bonds, commodities, or foreign currency.
In contrast, index-based equity portfolios will be invested solely in domestic equities. The portfolio’s holdings will mirror, as closely as possible, the holdings of the chosen underlying benchmark index. Portfolio holdings will only change when the composition of the underlying index changes.
Indexing – A Final Word
Indexing can refer to either economic indexes or market indexes designed to reflect the performance of the overall market. Economists, market analysts, and investors all pay attention to the performance of major indices to help them predict future economic trends and market price movements.