You might have heard about passive investing. It’s a strategy that requires minimal work and yields decent returns while preserving your capital over decades. Passive investing usually involves market indices. But what are they, and how does the process of investing in them look exactly? In this guide, we want to help you understand what an index is, why the type of index you choose depends on your goals, and your options when investing in one.
What is an Index?
A market index is simply a tool that we use to measure the performance of a market.
The idea behind its creation is that there is always a small sample of securities (stocks or bonds, for instance) in a certain market that can represent the performance of the whole market. The job of an index is, therefore, to track the performance of each security it includes giving us a general idea of the whole market’s performance.
For example, the Dow Jones Industrial Average (DJIA) is supposed to track the performance of the US stock market. Based on some criteria, they track the prices of 30 stocks at any time. Whenever a stock doesn’t fulfill the criteria of the index anymore, it will be replaced with another one.
For this reason, it’s also helpful to think of indices as theoretical portfolios of securities.
Though indices that track the stock market are ubiquitous, there are indices for any industry, sector, or stock market theme you can think of. You can find indices that track the Energy sector, the Biotechnology industry, and even modern markets like crypto and cannabis.
Obviously, the general purpose of an index is to offer an overview of a market’s performance. But there are two common ways that this is of practical use to investors.
The first is using an index as a benchmark. This is for investors who trade securities of a certain market and aim to yield better returns than the market. An index that tracks that market would allow them to see how much better or worse they do.
Another equally valuable way to use an index is to invest in the underlying securities of an index as a means to do as well as the market it tracks; or essentially invest in that market if you like. This is called index investing...
Who Is Index Investing for?
Index investing is for those investors who want to get easy exposure to a market without having to worry about managing their portfolios on their own.
Imagine having to buy every single stock of the Oil and Gas industry. This would require a very large fund to pull off. Having an index to follow instead would make things much easier.
At the same time, some indices include hundreds and even thousands of stocks and make frequent changes to the stocks they include. Trying to follow such an index on your own would be very challenging, even if you had the fund size required.
That’s where some special investment vehicles called index funds come in. These are basically professionally managed funds whose sole purpose is to track an index by investing in the stocks it includes at any time.
There are two types of index funds: mutual funds and ETFs. Let us examine both, one by one...
Mutual funds are investment vehicles that pool money from multiple investors to manage. When you invest in a mutual fund, you essentially give your money to a professional team of investors to buy and sell securities for you.
Since we will talk about ETFs in a bit, you already understand that index funds aren’t necessarily mutual funds. But mutual funds aren’t always index funds either.
Mutual fund managers can either employ an active or a passive investment strategy. Only when they go with the latter and track an index, they are considered index funds.
If you invest in a mutual fund that tracks an index, you indirectly buy all of the securities of the index that the mutual fund managers have invested in. For instance, if you invested in a mutual fund that tracked the S&P Aerospace & Defense Select Industry Index, you would essentially invest in all of the companies that best represent that industry at any time.
Whatever changes occur in the index regarding the securities it includes, the mutual fund managers will adjust the portfolio accordingly to reflect the changes. In other words, you will always track the performance of the index as closely as possible.
ETFs (Exchange-Traded Funds) are investment vehicles managed by professionals and traded on exchanges just like stocks.
It essentially consists of multiple underlying securities that you can indirectly trade by trading the ETF. You can also view an ETF as a bundle of securities that buying it would essentially make you the owner of all of them.
ETFs, like mutual funds, can follow all kinds of strategies, including a passive one where it would track an index. ETFs that track indices are also called index funds.
Now, the basic difference ETFs have with mutual funds is related to their structures. ETFs are securitized, meaning that they are financial instruments listed on exchanges and have prices just like any other security. Mutual funds, on the other hand, are more like corporations that manage your money.
For this reason, ETFs have much higher liquidity than mutual funds. You can buy and sell an ETF on the spot. This isn’t the case with mutual funds, however, orders to buy and sell are executed once per day in most cases.
How Do you Start?
Now that you understand what market indices are and how you can invest in them, you are ready to take the next step.
Make sure that you select the right index fund by learning what you should look for.
Also, if you haven’t opened a brokerage account yet, you’re lucky. We have created a free tool that asks you a few questions about your investment needs and presents you with the brokers who can cover those needs.
Take (literally) a minute and find your ideal broker today!