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.

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, the Institute for Supply Management’s Manufacturing Index and the Composite 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.

Key Takeaways

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

Indexing 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. Investors and market participants use these indices 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 rather than an exchange-traded fund tracking the S&P 500.

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 indices. They can also be managed as a fund of funds with mutual funds or exchange-traded funds as their base holdings.

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 indices that track the energy industry. These tracking funds are based on a range of filters including fundamentals, dividends, growth characteristics and more.