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Indexing

A statistical measure that is used to track the economic data of various publicly traded companies

What is Indexing?

Indexing is a passive investment strategy where you construct a portfolio to track the performance of a market index. This is common with the S&P 500, where investors try and mimic the performance of the index. Indexing is also used to gauge  the performance of economic activity. A great example is the Consumer Price Index (CPI), which is used to estimate the purchasing power parity of a currency, as well as its periodic change is used to measure inflation.

 

Indexing - Index display image

 

Further examples, the S&P 500 and the Dow Jones Industrial Average (DJIA) are used to track the performance of the US financial markets, while the NASDAQ Composite Index tracks the performance of large companies in order to predict economic trends.

 

Uses of Indexing

There are two main uses of indexing in financial markets. They include:

 

1. Gauge for linking values

The Consumer Price Index (CPI) provides a basis for calculating the cost of living adjustment (COLA), which shows the current cost of living based on the changes in prices of consumer goods and services. Pension plans also rely on the CPI to adjust the retirement benefit to be paid out.

The benefits must reflect any changes in the cost of living, such as increased inflation, higher fuel costs, and increased food prices. The CPI tracks the changes in the prices of consumer goods and services in a specific location. Apart from calculating the COLA and retirement benefit payouts, the CPI is also used to adjust salaries and interest rates.

 

2. Indicators of economic trends

Indexes or indices can also be used as indicators of economic trends by looking at the performance of the largest publicly traded companies and keeping track of specific indices about the market performance. Examples of such indices include the Index of leading economic indicators, Purchasing Managers’ Index, Labor Market Index and the GDP deflator index. The indexes provide an overview of the current economic trends and also predict future trends or patterns.

 

Indexes in the Investment Market

Two of the world’s best-known indices are the Standard & Poors 500 (S&P 500) and the Dow Jones Industrial Average (DJIA). The indices are discussed in detail below:

 

S&P 500

The S&P 500 comprises about 70% of all the stocks traded in the United States, and it is one of the most tracked benchmarks for measuring the performance of the stock market. It is based on the market capitalization of 500 public companies that are listed in NASDAQ and the New York Stock Exchange.

Unlike other indices in the United States, the S&P 500 uses the capitalization-weighted methodology and comprises diverse stocks. The index’s components are determined by a committee that evaluates potential stocks for listing based on their liquidity, public float, sector classification, market capitalization, financial viability, etc. The companies must also meet certain requirements set by the index.

 

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 in the NYSE or NASDAQ. The DJIA uses the price-weighted method, such that high-priced stocks are awarded greater weights than low-priced stocks.

The DJIA stocks are usually selected by editors of The Wall Street Journal. If one of the listed publicly-traded companies experiences financial turmoil and 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 by replicating specific indices such as a fixed income or equity index. This can commonly be achieved  purchase exchange-traded funds that track the underlying stock, bond or commodity.

Index investing assumes a passive form of investing, which offers better outcomes than actively managed indices since it eliminates any forms of bias or uncertainties in trading. Due to the passive approach, management fees and expense ratios are lower, allowing investors to realize consistent returns.

 

Active Investing vs. Passive Investing

In active investing, portfolio managers use their skills to beat the market by investing in a select number of stocks that they consider attractive and that offer long-term growth potential. Due to the volatility of the market, the market information and stock prices change often, which means that the manager must continually invest in new stocks in order to generate returns continuously. However, such an approach is affected by the uncertainties in the market and the biases of the manager.

In passive investing, portfolio managers attempt to reduce their risk exposure by dividing capital across multiple types of investments. It means that the manager can invest in local stocks, international stocks, as well as in the bond market.

Unlike active investing, the managers in passive investing do not have a lot to do in selecting the most attractive stocks. Instead, the capital is divided and invested in multiple portfolios that will earn them a positive market return. The manager decides the portfolios they want to invest in, the amount to invest, and then uses index funds to actualize that plan.

 

More Resources

CFI is the official provider of the Financial Modeling and Valuation Analyst (FMVA)™ certification program, designed to transform anyone into a world-class financial analyst.

To keep learning and developing your knowledge of financial analysis, we highly recommend the additional resources below:

  • NASDAQ Composite
  • Investing: A Beginner’s Guide
  • Price-Weighted Index
  • Tracking Error

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