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 referring to an index. In the United States, some popular indexes are the Standard & Poor's 500 Index (S&P 500), the Nasdaq and the Dow Jones Industrial Average (DJIA).

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

Key Takeaways

  • Market indexes are used as important benchmarks in measuring the returns of various assets such as the stock market.
  • Index investing has become increasingly popular over the years, with this passive strategy outperforming more active investment over time, especially net of fees and taxes.
  • Owning an index can only be accomplished indirectly, either through self indexing, index derivatives, or index funds & ETFs.

Indexing

First is to try to replicate the index yourself, in a process known as indexing. This way, you can create your own 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, and the information about index components and their percentage weights is publicly available on several financial or investing websites.

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 an extensive portfolio and make hundreds of transactions a year.

Enhanced indexing, sometimes known as a smart beta strategy, is an investment approach that attempts to amplify the returns of an underlying portfolio or index, while minimizing tracking error. This type of investing could be considered a hybrid between active and passive management and is used to describe any strategy that is used in conjunction with index funds for the purpose of outperforming a specific benchmark.

Whichever indexing strategy you use, it will take time and effort to construct the right portfolio. It will also require a significant amount of transaction costs, as you will need to buy, for instance, 500 individual stock orders to capture the S&P 500. Commissions, in such a case, can really add up making it very costly to do.

Index Futures & Options

If your brokerage account is set up for derivatives trading, a third way to invest in an index is through futures or options contracts listed on the index.

Index futures are futures contracts where a trader can buy or sell a financial index today to be settled at a future date. Index futures are used to speculate on the direction of price movement for an index such as the S&P 500. Investors and investment managers will also use index futures to hedge their equity positions against losses. Index futures, like all future contracts, give the trader or investor the power and the commitment to deliver the cash value based on an underlying index at a specified future date. Unless the contract is unwound before the expiration through an offsetting trade, the trader is obligated to deliver the cash value on the expiry.

An index option, on the other hand, is a financial derivative that gives the contract holder the right, but not the obligation, to buy or sell the value of an underlying index, such as the Standard and Poor's (S&P) 500, at the stated exercise price on or before the expiration date of the option. No actual stocks are bought or sold; index options are always cash-settled, and are typically European-style options.

With either futures or options, these contracts come with expiration dates, and you will have to roll your position forward into a new contract as expiration approaches or else they will cease to track the index for you. This requires planning and can be costly to continually purchase and sell contracts.

Index Mutual Funds & ETFs

Index funds 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.

Exchange-traded funds (ETFs) similarly track an indexlike index funds, but trade like a stock 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.

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.

The Bottom Line

Investing in an index can only be done indirectly, but index mutual funds and ETFs are now very liquid, cheap to own, and may come with zero commissions. They are the perfect set-it-and-forget-it index option. Indexing on your own requires time and effort for researching and building the proper portfolio and can be costly to implement. Derivatives trading utilizes specialized knowledge and often requires a margin account with futures and options trading approval, and will require you to roll positions as they expire.