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.

  1. Should mutual funds be subject to more regulation?

    Mutual funds, when compared to other types of pooled investments such as hedge funds, have very strict regulations. In fact, ... Read Full Answer >>
  2. Can hedge fund returns be replicated?

    You can replicate hedge fund returns to a degree but not perfectly. Most replication strategies underperform hedge funds ... Read Full Answer >>
  3. Does mutual fund manager tenure matter?

    Mutual fund investors have numerous items to consider when selecting a fund, including investment style, sector focus, operating ... Read Full Answer >>
  4. Do ETFs pay capital gains?

    Exchange-traded funds (ETFs) can generate capital gains that are transferred to shareholders, typically once a year, triggering ... Read Full Answer >>
  5. How do real estate hedge funds work?

    A hedge fund is a type of investment vehicle and business structure that aggregates capital from multiple investors and invests ... Read Full Answer >>
  6. Are Vanguard ETFs commission-free?

    While some Vanguard exchange-traded funds (ETFs) are available commission-free from third-party brokers, a large portion ... Read Full Answer >>
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  1. Benchmark

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  2. Equity Risk Premium

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  3. Alpha

    Alpha is used in finance to represent two things: 1. a measure ...
  4. Exchange-Traded Fund (ETF)

    A security that tracks an index, a commodity or a basket of assets ...
  5. Compound Annual Growth Rate - CAGR

    The Compound Annual Growth Rate (CAGR) is the mean annual growth ...
  6. Return On Investment - ROI

    A performance measure used to evaluate the efficiency of an investment ...

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