DEFINITION of 'Index Investing'

Index investing is a passive strategy that attempts to generate similar returns as a broad market index. Investors use index investing to replicate the performance of a specific index – generally an equity or fixed-income index – by purchasing exchange-traded funds (ETF) that closely track the underlying index. There are numerous advantages of index investing. For one thing, empirical research finds index investing tends to outperform active management over a long time frame. Taking a hands off approach to investing eliminates many of the biases and uncertainties that arise in a stock picking strategy.  

BREAKING DOWN 'Index Investing'

Index investing is an effective strategy to manage risk and gain consistent returns. Proponents of the strategy eschew active investing because modern financial theory claims it's impossible to "beat the market" once trading costs and taxes are taken into account. Since index investing takes a passive approach, index funds usually have lower management fees and expense ratios than actively managed funds. The simplicity of tracking the market without a portfolio manager allows providers to maintain modest fees. Index funds also tend to be more tax efficient than active funds because they make less frequent trades.

More importantly, index investing is an effective method of diversifying against risks. In other words, an index fund consists of a broad basket of assets instead of a few investments. This serves to minimize unsystematic risk related to a specific company or industry without decreasing expected returns. For many index investors, the S&P 500 is the most common benchmark to evaluate performance against, as it gauges the health of the US economy. Other widely followed index funds track the performance of the Dow Jones Industrial Average and corporate bond sector (AGG). 

Limitations of Index Investing

Despite gaining immense popularity in recent years, there are some limitations to index investing. Many index funds, like the S&P 500, are formed on a market capitalization basis, meaning the top holdings have an outsized weight on broad market movements. If Amazon (AMZN) and Facebook (FB), for instance, experience a weak quarter it would have a noticeable impact on the entire index. This entirely passive strategy neglects a subset of the investment universe focused on market factors like value, momentum, and quality.

These factors now constitute a corner of investing called smart-beta, which attempts to deliver better risk adjusted returns than a market cap weighted index. Smart-beta funds offer the same benefits of a passive strategy with the additional upside of active management, otherwise known as alpha.

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