Index Investing

What Is an Index?

Most indexes are a collection of securities that provide a statistical measure of a market or a subset of a market. The earliest indexes were designed to gauge the market's general direction. For example, the Dow Jones^® Industrial Average (DJIA^®) was created in 1896 by Charles Dow and originally tracked the performance of 12 large U.S. stocks. The DJIA, like the S&P 500^® and Wilshire 5000^®, now serves as a benchmark of how well all stocks on the American markets perform each day.

How Indexes Work

Whether an index was created to gauge the performance of the market, or as a benchmark to measure the performance of an investment manager, most indexes are comprised of securities. Some indexes use objective and transparent rules to determine their constituent securities, while others are more subjective.

Reconstitution, or the periodic rebalancing of an index, is important because security characteristics change over time. For example, a small cap security can grow into a mid cap over time. The timing of reconstitution is important, because it allows for close mirroring of the market. Indexes need to be reconstituted regularly; too frequent reconstitution, however, can result in turnover costs for investors.

About Index Products

Although you cannot purchase an index, you can get investment exposure to an index by choosing from a variety of products based on an index. Index products include index mutual funds, exchange-traded funds (ETFs), unit investment trusts (UITs), and index futures and options.

Index products are appealing to some because there may be less risk than investing in a single stock, and because they generally have low fees. Index products can also be tax efficient: the investment manager of an index mutual fund essentially buys the securities that comprise the index and then holds them until the index is reconstituted. This "passive" investing often results in low security turnover, minimizing the potential for capital gains recognition at the fund level.

Passively-Managed vs. Actively-Managed Funds

A long-standing debate exists about the merits of passively-managed (index funds) and actively-managed funds ( traditional mutual funds).

Active management is the deliberate selection of securities — unlike passive index investing, which closely follows the stocks in a particular index. Because active managers perform research to select only the stocks that they believe will outperform the market, their funds tend to have higher expense ratios to compensate the managers and research staff.

An index fund manager attempts to replicate the performance of the underlying index by buying all the stocks that constitute the index, or uses statistical sampling to the extent that buying all stocks is unreasonable. The manager then holds the stock in the fund until the index is reconstituted. Index fund managers don't rely on a research staff, nor do they buy and sell securities as frequently, so the expense ratios tend to be much lower.

Which Is Right for You?

Supporters of active management believe that, over time, research of companies and industries can result in better stock selection and superior performance, thus justifying the management fees. Supporters of index funds believe that all information about the current and future prospects of a company are already reflected in the price of the stock, and that over time active managers will underperform because of their higher fees. Although the debate continues, there is likely a role for both passive and active investments in a well-balanced portfolio.