A:

First, let's review the definition of an index. An index is essentially an imaginary portfolio of securities representing a particular market or a portion of it. When most people talk about how well the market is doing, they are actually referring to an index. In the U.S., some popular indexes are the Standard & Poor's 500 Index (S&P 500), the Nasdaq composite and the Dow Jones Industrial Average (DJIA). (You can read more about different indexes in the article A Market by Any Other Name.)

While you cannot actually buy indexes (which are just benchmarks), there are three ways for you to mirror their performance:

  1. Indexing - You can create a portfolio of securities that best represents an index, such as the S&P 500. The stocks and the weightings of your allocations would be the same as in the actual index. Adjustments would have to be made periodically to reflect changes in the index. This method can be quite costly, since it requires an investor to create a large portfolio and make hundreds of transactions a year.

  2. Buy index funds - These are a cheap way to mimic the marketplace. While index funds do charge management fees, they are usually lower than those charged by the typical mutual fund. There are a variety of index fund companies and types to choose from, including international index funds and bond index funds. To learn more about the variety of indexes and the calculations involved, check out our Index Investing tutorial. (To read more about fees and index funds, see You Can't Judge an Index Fund by Its Cover.)

  3. Exchange-traded fund (ETF) - This is a security that tracks an index and, like an index fund, represents a basket of stocks but, like a stock, trades on an exchange. You can buy and sell ETFs just as you would trade any other security. The price of an ETF reflects its net asset value (NAV), which takes into account all the underlying securities in the fund. (Read more about ETFs in the article Spiders, Diamonds and Investing?)


Because index funds and ETFs are designed to mimic the marketplace or a sector of the economy, they require very little management. The beauty of these financial instruments is that they offer the diversification of a mutual fund at a much lower cost.

RELATED FAQS
  1. Why can you short sell an ETF but not an index fund?

    To answer this question, we should first define exactly what an index fund is. An index fund is a mutual fund, or a basket ... Read Answer >>
  2. What's the difference between an index fund and an ETF?

    Learn about the difference between an index fund and an exchange-traded fund and how index fund investing compares to value ... Read Answer >>
  3. Who's in charge of managing exchange-traded funds?

    An exchange-traded fund (ETF) is a security that tracks an index but has the flexibility of trading like a stock. Just like ... Read Answer >>
  4. How does a point change in a major index effect its equivalent exchange-traded fund?

    The S&P 500 and Dow Jones Industrial Index (DJIA) are two of the most well-known indexes tracking the movement of the U.S. ... Read Answer >>
Related Articles
  1. Investing

    The Pros and Cons of Indexes

    Learn about the advantages and disadvantages of stock indexes and passive index funds. Discover how there is an opportunity cost to using index funds.
  2. Investing

    ETF Tracking Errors: Protect Your Returns

    Tracking errors tend to be small, but they can still adversely affect your returns. Learn how to protect against them.
  3. Investing

    The Hidden Differences Between Index Funds

    These funds don't all match index returns. Find out how to avoid costly surprises.
  4. Investing

    Enhanced Index Funds: Can They Deliver Low-Risk Returns?

    These funds may look appealing. Find out whether they can really live up to all of their promises.
  5. Investing

    3 Index Funds with the Lowest Expense Ratios

    Read detailed information about index mutual funds with some of the lowest expense ratios in their categories, and learn about their pros and cons.
  6. Investing

    What is an Index?

    An index is a statistical means of calculating a change in an economy or market.
  7. Investing

    What are Index Funds?

    An index fund is a type of mutual fund that is tied to a broad stock index like the S&P 500 or the Dow Jones Industrial Average, instead of being handpicked and managed by an investment manager. ...
  8. Investing

    ETFs Can Be Safe Investments, If Used Correctly

    Learn about how ETFs can be a safe investment option if you know which funds to choose, including the basics of both indexed and leveraged ETFs.
  9. Financial Advisor

    The 4 Best U.S. Equity Index Mutual Funds

    Find out which four index mutual funds are among the best U.S. equities index mutual funds for core holdings in your investment portfolio.
  10. Investing

    The Lowdown On Index Funds

    If you can't beat the market, why not join it? Read on to go over your options.
RELATED TERMS
  1. Index Fund

    An index fund is a type of mutual fund with a portfolio constructed ...
  2. Index ETF

    Exchange-traded funds that follow a specific benchmark index ...
  3. Index

    A statistical measure of change in an economy or a securities ...
  4. Total Return Index

    A type of equity index that tracks both the capital gains of ...
  5. Tracker Fund

    An index fund that tracks a broad market index or a segment thereof. ...
  6. Composite

    A grouping of equities, indexes or other factors combined in ...
Hot Definitions
  1. Graduate Record Examination - GRE

    A standardized exam used to measure one's aptitude for abstract thinking in the areas of analytical writing, mathematics ...
  2. Graduate Management Admission Test - GMAT

    A standardized test intended to measure a test taker's aptitude in mathematics and the English language. The GMAT is most ...
  3. Magna Cum Laude

    An academic level of distinction used by educational institutions to signify an academic degree which was received "with ...
  4. Cover Letter

    A written document submitted with a job application explaining the applicant's credentials and interest in the open position. ...
  5. 403(b) Plan

    A retirement plan for certain employees of public schools, tax-exempt organizations and certain ministers. Generally, retirement ...
  6. Master Of Business Administration - MBA

    A graduate degree achieved at a university or college that provides theoretical and practical training to help graduates ...
Trading Center