What is Indexing?

Indexing is a passive investment strategy that seeks to mimic or exceed the returns of a designated market index or other proxy.

How Does Indexing Work?

The strategy requires an investor to first choose an index to mimic. The index could be a well-known market index or it could be an index created especially for the investor. There are literally hundreds of established indexes investors can replicate.

Some indexes are exceptionally broad, such as the Nasdaq Composite Index or the Wilshire 5000 Index, which is considered the 'total market index' because it contains several thousand stocks. Some indexes are very narrow, such as the American Stock Exchange Biotech Index (BTK), which measures the performance of 17 companies chosen to represent the biotech sector. There are also many international indexes designed to measure the performance of foreign markets. One of the most common is the Financial Times 100 Index, or FTSE, which measures the performance of equities traded on the London Stock Exchange.

The Dow Jones Industrial Average is probably the best-known and most widely followed financial index in the world. It consists of 30 of the largest publicly traded firms in the United States. The S&P 500 Index is also very common, comprising more than 70% of the total market cap of all stocks traded in the United States. The Nasdaq Composite is a broad market index that encompasses about 4,000 issues traded on the Nasdaq National Market -- virtually every firm that trades on the exchange.

For practical reasons, investors usually don't purchase all of the securities in an index. Doing so would be very expensive and time-consuming. Thus, investors usually have three choices when using an index strategy. They can choose a very narrow index that represents only a small portion of the market (such as the American Stock Exchange Biotech Index). Investors also can purchase a random sample of securities in an index (this is called a sampling approach) or they can purchase a set number of securities in each segment of an index (this is called a stratified approach). Some research suggests that investors can nearly replicate an index's performance by purchasing as few as 40 of the index's underlying securities.

Why Does Indexing Matter?

Indexing is one of four general types of investing strategies (the other three are the buy-and-hold, structured portfolio and active strategies). The strategy is primarily for long-term investors who want their returns to follow the market (i.e., they want to take on some market risk). The strategy limits this market risk and therefore limits returns.

Whether to use indexing is fundamentally a matter of the investor's opinion of whether securities prices always reflect all available information (i.e., the investor believes in the efficient markets theory). If the investor espouses this theory, then there is no such thing as an undervalued or overvalued security to that investor, and an active income investing strategy will not consistently produce returns that exceed the index after accounting for the added risks and transaction costs involved in the associated frequent buying and selling.

However, the fact that the investor must first select an appropriate index to pursue and then decide which underlying securities to purchase is why indexing is not a totally passive strategy. It usually involves more transaction costs than the buy-and-hold strategy and it also involves more active reinvestment of the proceeds and even rebalancing if the index changes. These factors also mean the investor's returns will be somewhat different than the index's returns. This is why the easiest way to implement indexing is to simply purchase shares of an index fund or ETF that tracks a particular index and let the fund manager handle many of these duties (for a fee, of course).