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.

RELATED TERMS
  1. Indexing

    In the financial markets, indexing can be used as a statistical ...
  2. Index Fund

    An index fund is a portfolio of stocks or bonds that is designed ...
  3. Passive Management

    A style of management associated with mutual and exchange-traded ...
  4. Index ETF

    Index ETFs are exchange-traded funds that seek to track a benchmark ...
  5. Fundamentally Weighted Index

    A fundamentally weighted index is a type of equity index in which ...
  6. Actively Managed ETF

    An active managed ETF is a form of exchange-traded fund that ...
Related Articles
  1. Investing

    The Lowdown On Index Funds

    If you can't beat the market, why not join it? Read on to go over your options.
  2. Investing

    How to Determine the Best Investment Strategy for You

    Before choosing passive or active investing for your portfolio, understand the differences.
  3. Financial Advisor

    The 4 Best U.S. Equity Index Mutual Funds

    Find out which four index mutual funds are among the best U.S. equities index mutual funds for core holdings in your investment portfolio.
  4. Investing

    Enhanced Index Funds: Can They Deliver Low-Risk Returns?

    These funds may look appealing. Find out whether they can really live up to all of their promises.
  5. Investing

    3 Index Funds with the Lowest Expense Ratios

    Read detailed information about index mutual funds with some of the lowest expense ratios in their categories, and learn about their pros and cons.
  6. Investing

    4 Reasons Most ETFs are Passively Managed

    Find out the top four reasons most ETFs are passively managed, including the benefits of lower costs, greater tax efficiency and low asset turnover.
  7. Investing

    Passively Managed Vs. Actively Managed Mutual Funds: Which is Better?

    Learn about the differences between actively and passively managed mutual funds, and for which types of investors each management style is best suited.
  8. Investing

    The Hidden Differences Between Index Funds

    These funds don't all match index returns. Find out how to avoid costly surprises.
  9. Investing

    Why Index Fund Investing Works

    Over time, index fund investing gained traction and ultimately reshaped the industry. Today, these once obscure funds comprise more than 22 percent of equity mutual fund assets, according to ...
RELATED FAQS
  1. How Do I Find Mutual Funds That Track Indexes?

    Two good sources for finding index funds are Fidelity Investments and Vanguard. Read Answer >>
  2. Is it possible to invest in an index?

    While you cannot buy indexes, which are just benchmarks, there are three ways for you to mirror their performance. Read Answer >>
  3. What are the disadvantages of an index fund over an actively managed fund?

    Read the advantages an actively managed fund has over its more staid compatriot, the indexed fund, and make your own decision ... Read Answer >>
  4. Can an Index Fund Investor Lose Everything?

    There is almost zero chance that any index fund could ever lose all of its value. Read Answer >>
Hot Definitions
  1. Cost of Goods Sold - COGS

    Cost of goods sold (COGS) is the direct costs attributable to the production of the goods sold in a company.
  2. Profit and Loss Statement (P&L)

    A financial statement that summarizes the revenues, costs and expenses incurred during a specified period of time, usually ...
  3. Monte Carlo Simulation

    Monte Carlo simulations are used to model the probability of different outcomes in a process that cannot easily be predicted ...
  4. Price Elasticity of Demand

    Price elasticity of demand is a measure of the change in the quantity demanded or purchased of a product in relation to its ...
  5. Sharpe Ratio

    The Sharpe ratio is the average return earned in excess of the risk-free rate per unit of volatility or total risk.
  6. Capital Expenditure (CAPEX)

    Capital expenditure, or CapEx, are funds used by a company to acquire or upgrade physical assets such as property, industrial ...
Trading Center