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. 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 >>
Related Articles
  1. Investing Basics

    5 Simple Ways To Invest In Real Estate

    There are many ways to invest in real estate. Here are five of the most popular.
  2. Investing Basics

    5 Common Mistakes Young Investors Make

    Missteps are common whenever you’re learning something new. But in investing, missteps can have serious financial consequences.
  3. Chart Advisor

    ChartAdvisor for February 5, 2016

    Weekly technical summary of the major U.S. indexes.
  4. Mutual Funds & ETFs

    The 4 Best American Funds for Growth Investors in 2016

    Discover four excellent growth funds from American Funds, one of the country's premier mutual fund families with a history of consistent returns.
  5. Products and Investments

    A Guide to DIY Portfolio Management

    These are some of the pillars needed to build a DIY portfolio.
  6. Mutual Funds & ETFs

    The 5 Best US Small Cap Value Index Mutual Funds

    Find out which index mutual funds do the best at investing in small-cap value stocks for higher potential returns at the lowest cost.
  7. Mutual Funds & ETFs

    The 4 Best Vanguard Funds for Growth Investors in 2016

    Discover four mutual funds managed by the Vanguard Group that would be attractive for investors interested in investing in growth stocks in 2016.
  8. Investing Basics

    Building My Portfolio with BlackRock ETFs and Mutual Funds (ITOT, IXUS)

    Find out how to construct the ideal investment portfolio utilizing BlackRock's tools, resources and its popular low-cost exchange-traded funds (ETFs).
  9. Mutual Funds & ETFs

    Top 3 Thornburg Funds for Retirement Diversification in 2016

    Learn about the Thornburg family of mutual funds and the top three funds that you should consider for retirement diversification in 2016.
  10. Mutual Funds & ETFs

    The 4 Best Fidelity Funds for Income Seekers in 2016

    Discover the four best fixed-income mutual funds administered and managed by Fidelity Investments suitable for income-seeking investors.
RELATED TERMS
  1. Sortino Ratio

    A modification of the Sharpe ratio that differentiates harmful ...
  2. Benchmark

    A standard against which the performance of a security, mutual ...
  3. Equity Risk Premium

    The excess return that investing in the stock market provides ...
  4. Alpha

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

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

    The Compound Annual Growth Rate (CAGR) is the mean annual growth ...
Hot Definitions
  1. Discouraged Worker

    A person who is eligible for employment and is able to work, but is currently unemployed and has not attempted to find employment ...
  2. Ponzimonium

    After Bernard Madoff's $65 billion Ponzi scheme was revealed, many new (smaller-scale) Ponzi schemers became exposed. Ponzimonium ...
  3. Quarterly Earnings Report

    A quarterly filing made by public companies to report their performance. Included in earnings reports are items such as net ...
  4. Dark Pool Liquidity

    The trading volume created by institutional orders that are unavailable to the public. The bulk of dark pool liquidity is ...
  5. Godfather Offer

    An irrefutable takeover offer made to a target company by an acquiring company. Typically, the acquisition price's premium ...
Trading Center