What Is an Index?

An index is a method to track the performance of a group of assets in a standardized way. Indexes typically measure the performance of a basket of securities intended to replicate a certain area of the market. These could be a broad-based index that captures the entire market, such as the Standard & Poor's 500 Index or Dow Jones Industrial Average (DJIA), or more specialized such as indexes that track a particular industry or segment.

Key Takeaways

  • An index measures the price performance of a basket of securities using a standardized metric and methodology.
  • Indexes in financial markets are often used as benchmarks to evaluate an investment's performance against.
  • Passive index investing has become a popular low-cost way to replicate the returns of popular indices such as the S&P 500 Index or Dow Jones Industrial Average.
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Index

Understanding Indexes

Indexes are also created to measure other financial or economic data such as interest rates, inflation, or manufacturing output. Indexes often serve as benchmarks against which to evaluate the performance of a portfolio's returns. One popular investment strategy, known as indexing, is to try to replicate such an index in a passive manner rather than trying to outperform it.

An index is an indicator or measure of something. In finance, it typically refers to a statistical measure of change in a securities market. In the case of financial markets, stock and bond market indexes consist of a hypothetical portfolio of securities representing a particular market or a segment of it. (You cannot invest directly in an index.) The S&P 500 Index and the Bloomberg Barclays US Aggregate Bond Index are common benchmarks for the U.S. stock and bond markets, respectively.  In reference to mortgages, it refers to a benchmark interest rate created by a third party.

Each index related to the stock and bond markets has its own calculation methodology. In most cases, the relative change of an index is more important than the actual numeric value representing the index. For example, if the FTSE 100 Index is at 6,670.40, that number tells investors the index is nearly seven times its base level of 1,000. However, to assess how the index has changed from the previous day, investors must look at the amount the index has fallen, often expressed as a percentage.

Index Investing

Indexes are also often used as benchmarks against which to measure the performance of mutual funds and exchange-traded funds (ETFs). For instance, many mutual funds compare their returns to the return in the S&P 500 Index to give investors a sense of how much more or less the managers are earning on their money than they would make in an index fund.

"Indexing" is a form of passive fund management. Instead of a fund portfolio manager actively stock picking and market timing—that is, choosing securities to invest in and strategizing when to buy and sell them—the fund manager builds a portfolio wherein the holdings mirror the securities of a particular index. The idea is that by mimicking the profile of the index—the stock market as a whole, or a broad segment of it—the fund will match its performance as well.

Since you cannot invest directly in an index, index funds are created to track their performance. These funds incorporate securities that closely mimic those found in an index, thereby allowing an investor to bet on its performance, for a fee. An example of a popular index fund is the Vanguard S&P 500 ETF (VOO), which closely mirrors the S&P 500 Index.

When putting together mutual funds and ETFs, fund sponsors attempt to create portfolios mirroring the components of a certain index. This allows an investor to buy a security likely to rise and fall in tandem with the stock market as a whole or with a segment of the market.

Index Examples

The S&P 500 Index is one of the world's best-known indexes and one of the most commonly used benchmarks for the stock market. It includes 80% of the total stocks traded in the United States. Conversely, the Dow Jones Industrial Average is also well known, but represents stock values from just 30 of the nation's publicly traded companies. Other prominent indexes include the Nasdaq 100 Index, Wilshire 5000 Total Market Index, MSCI EAFE Index, and the Bloomberg Barclays US Aggregate Bond Index.

Like mutual funds, indexed annuities are tied to a trading index. However, rather than the fund sponsor trying to put together an investment portfolio likely to closely mimic the index in question, these securities feature a rate of return that follows a particular index but typically have caps on the returns they provide. For example, if an investor buys an annuity indexed to the Dow Jones and it has a cap of 10%, its rate of return will be between 0 and 10%, depending on the annual changes to that index. Indexed annuities allow investors to buy securities that grow along with broad market segments or the total market.

Adjustable-rate mortgages feature interest rates that adjust over the life of the loan. The adjustable interest rate is determined by adding a margin to an index. One of the most popular indexes on which mortgages are based is the London Inter-bank Offer Rate (LIBOR). For example, if a mortgage indexed to the LIBOR has a 2% margin and the LIBOR is 3%, the interest rate on the loan is 5%.