What is Indexing

Indexing is broadly referred to as an indicator or measure of something. In the financial markets, indexing can be used as a statistical measure for tracking economic data, a methodology for grouping a specific market segment or as an investment management strategy for passive investments.


In Financial Markets

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' Manufacturing Index, the Institute for Supply Management’s Manufacturing Index and the Index of Leading Economic Indicators.

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. Many pension plans use COLA and the Consumer Price Index as a measure for retirement benefit payout adjustments with the adjustment using inflation-based indexing measures.

In The Investment Market

In the investment market, indexes exist to represent specific market segments. Leading market indexes in the U.S. are the Dow Jones Industrial Average and the S&P 500. Indexes are constructed with specified methodologies. The Dow Jones Industrial Average is a price-weighted index giving greater weight to stocks in the index with a higher price. The S&P 500 Index is a market-capitalization weighted index giving 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.

Passive Investing and Tracker Funds

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. 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 an index by investing in an index fund. Most index funds have an expense ratio ranging from 0.10% to 0.25%. Index funds can be constructed using individual stocks and bonds. They can also be managed as a fund of funds with mutual funds or exchange-traded funds as their base holdings.

Index funds can also be called tracker funds. More complex indexing strategies may seek to replicate the holdings and return of a customized index. Customized index tracking funds have evolved as a low-cost investment option for investing in a screened subset of securities. Customized index funds track customized or screened indexes that are constructed based on a range of filters including fundamentals, dividends, growth characteristics and more.

Investors have many indexed investment options to choose from within the investment industry. Two of the leading index fund providers are State Street Global Advisors and BlackRock. State Street Global Advisors offers a wide range of index funds through its SPDR index series. BlackRock offers numerous index funds through its iShares series.