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. 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 >>
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  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 ...
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