What Is Indexing?

Indexing, broadly, refers to the use of some benchmark indicator or measure as a reference or yardstick. In finance and economics, indexing is used as a statistical measure for tracking economic data such as inflation, unemployment, gross domestic product (GDP) growth, productivity, and market returns.

Indexing may also refer to passive investment strategies that replicate benchmark indexes. Index investing has become increasingly popular over the past decades.

Key Takeaways

  • Indexing is the practice of compiling economic data into a single metric or comparing data to such a metric.
  • There are many indexes in finance that reflect on economic activity or summarize market activity—these become performance benchmarks against which portfolios and fund managers are measured.
  • Indexing is also used to refer to passively investing in market indexes to replicate broad market returns rather than actively selecting individual stocks.

Understanding Indexing

Indexing is used in the financial market as a statistical measure for tracking economic data. Indexes created by economists provide some of the market’s leading indicators for economic trends. Economic indexes closely followed in the financial markets include the Purchasing Managers' Index (PMI), the Institute for Supply Management’s Manufacturing Index (ISM), and the Composite Index of Leading Economic Indicators. These indexes are tracked to measure changes over time.

Statistical indexes may also be used as a gauge for linking values. The cost of living adjustment (COLA) is a statistical measure obtained through analysis of the Consumer Price Index (CPI) that indexes prices to inflation. Many pension plans and insurance policies use COLA and the Consumer Price Index as a measure for retirement benefit payout adjustments with the adjustment using inflation-based indexing measures.

Indexing in Financial Markets

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). Indexes can also be more specialized, such as indexes that track a particular industry or segment. The Dow Jones Industrial Average is a price-weighted index, which means it gives greater weight to stocks in the index with a higher price. The S&P 500 Index is a market capitalization-weighted index, which means it gives greater weight to stocks in the S&P 500 Index with a higher market capitalization.

Index providers have numerous methodologies for constructing investment market indexes. Investors and market participants use these indexes as benchmarks on performance. If a fund manager is underperforming the S&P 500 over the long term, for example, it will be hard to entice investors into the fund.

Indexes also exist that track bond markets, commodities, and derivatives.

Indexing and Passive Investing

Indexing is broadly known in the investment industry as a passive investment strategy for gaining targeted exposure to a specified market segment. The majority of active investment managers typically do not consistently beat index benchmarks. Moreover, investing in a targeted segment of the market for capital appreciation or as a long-term investment can be expensive given the trading costs associated with buying individual securities. Therefore, indexing is a popular option for many investors.

An investor can achieve the same risk and return of a target index by investing in an index fund. Most index funds have low expense ratios and work well in a passively managed portfolio. Index funds can be constructed using individual stocks and bonds to replicate the target indexes. They can also be managed as a fund of funds with mutual funds or exchange-traded funds as their base holdings.

Since index investing takes a passive approach, index funds usually have lower management fees and expense ratios (ERs) 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.

Indexing and Tracker Funds

More complex indexing strategies may seek to replicate the holdings and returns of a customized index. Customized index-tracking funds have evolved as a low-cost investment option for investing in a screened subset of securities. These tracker funds are essentially trying to take the best of the best within a category of stocks—for example, the best energy companies within the indexes that track the energy industry. These tracking funds are based on a range of filters, including fundamentals, dividends, growth characteristics, and more.