First, let's review the definition of an index. An index is essentially an imaginary portfolio of securities representing a particular market or a portion of it. When most people talk about how well the market is doing, they are referring to an index. In the United States, some popular indexes are the (S&P 500), the Nasdaqand the Dow Jones Industrial Average (DJIA).
While you cannot buy indexes (which are just benchmarks), there are three ways for you to mirror their performance.
Key Takeaways
- Market indexes are used as important benchmarks in measuring the returns of various assets such as the stock market.
- Index investing has become increasingly popular over the years, with this passive strategy outperforming more active investment over time, especially net of fees and taxes.
- Owning an index can only be accomplished indirectly, either through self indexing, index derivatives, or index funds & ETFs.
Indexing
First is to try to replicate the index yourself, in a process known as indexing. This way, you can create your own portfolio of securities that best represents an index, such as the S&P 500. The stocks and the weightings of your allocations would be the same as in the actual index, and the information about index components and their percentage weights is publicly available on several financial or investing websites.
Adjustments would have to be made periodically to reflect changes in the index. This method can be quite costly since it requires an investor to create an extensive portfolio and make hundreds of transactions a year.
Enhanced indexing, sometimes known as a smart beta strategy, is an investment approach that attempts to amplify the returns of an underlying portfolio orindex, while minimizingtracking error. This type of investing could be considered a hybrid between active and passive management and is used to describe any strategy that is used in conjunction with index funds for the purpose of outperforming a specific benchmark.
Whichever indexing strategy you use, it will take time and effort to construct the right portfolio. It will also require a significant amount of transaction costs, as you will need to buy, for instance, 500 individual stock orders to capture the S&P 500. Commissions, in such a case, can really add up making it very costly to do.
Index Futures & Options
If your brokerage account is set up for derivatives trading, a third way to invest in an index is through futures or options contracts listed on the index.
Index futures arefutures contractswhere a trader can buy or sell a financial index today to be settled at a future date. Index futures are used to speculate on the direction of price movement for an index such as the S&P 500. Investors and investment managers will also use index futures to hedge their equity positions against losses. Index futures, like all future contracts, give the trader or investor the power and the commitment to deliver the cash value based on an underlying index at a specified future date. Unless the contract is unwound before the expiration through an offsetting trade, the trader is obligated to deliver the cash value on the expiry.
An index option, on the other hand, is a financial derivative that gives the contract holder the right, but not the obligation, to buy or sell the value of an underlyingindex, such as the Standard and Poor's (S&P) 500, at the stated exercise price on or before the expiration date of the option. No actual stocks are bought or sold; index options are alwayscash-settled, and are typicallyEuropean-style options.
With either futures or options, these contracts come with expiration dates, and you will have to roll your position forward into a new contract as expiration approaches or else they will cease to track the index for you. This requires planning and can be costly to continually purchase and sell contracts.
Index Mutual Funds & ETFs
Index fundsare a cheap way to mimic the marketplace. While index funds do charge management fees, they are usually lower than those charged by the typical mutual fund. There are a variety of index fund companies and types to choose from, including international index funds and bond index funds.
Exchange-traded funds (ETFs)similarly track an indexlike index funds, but trade like a stockon an exchange. You can buy and sell ETFs just as you would trade any other security. The price of an ETF reflects its net asset value (NAV), which takes into account all the underlying securities in the fund.
Because index funds and ETFs are designed to mimic the marketplace or a sector of the economy, they require very little management. The beauty of these financial instruments is that they offer the diversification of a mutual fund at a much lower cost.
The Bottom Line
Investing in an index can only be done indirectly, but index mutual funds and ETFs are now very liquid, cheap to own, and may come with zero commissions. They are the perfect set-it-and-forget-it index option. Indexing on your own requires time and effort for researching and building the proper portfolio and can be costly to implement. Derivatives trading utilizes specialized knowledge and often requires a margin account with futures and options trading approval, and will require you to roll positions as they expire.
FAQs
Index investing has become increasingly popular over the years, with this passive strategy outperforming more active investment over time, especially net of fees and taxes. Owning an index can only be accomplished indirectly, either through self indexing, index derivatives, or index funds & ETFs.
Can you invest directly in an index? ›
You can buy index funds through your brokerage account or directly from an index-fund provider, such as Fidelity. When you buy an index fund, you get a diversified selection of securities in one easy, low-cost investment.
Are indexes a good investment? ›
Index funds can be an excellent option for beginners stepping into the investment world. They are a simple, cost-effective way to hold a broad range of stocks or bonds that mimic a specific benchmark index, meaning they are diversified.
Can I buy index funds on my own? ›
You can either open an account with the broker that offers the fund you want, or you can simply open an account with your preferred broker. Many of the major brokers offer their own index funds but they tend to largely track the major indices, so performance should be similar across brokers.
How risky is index investing? ›
Asset prices can rise and fall rapidly and investors must accept the fact that the value of their index based investment may fluctuate by as much as 50% or more in a year. General market risk can relate to a particular sector. For example, mining sector indices are usually more volatile than industrial sector indices.
Do billionaires invest in index funds? ›
There are many ways to start investing, but one that's worked for billionaires like Warren Buffett is investing in low-cost index funds.
What is the cheapest S&P 500 index fund? ›
What's the best S&P 500 index fund?
| Index fund | Minimum investment | Expense ratio |
|---|
| Vanguard 500 Index Fund - Admiral Shares (VFIAX) | $3,000. | 0.04%. |
| Schwab S&P 500 Index Fund (SWPPX) | No minimum. | 0.02%. |
| Fidelity 500 Index Fund (FXAIX) | No minimum. | 0.015%. |
| Fidelity Zero Large Cap Index (FNILX) | No minimum. | 0.0%. |
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As with all investments, it is possible to lose money in an index fund, but if you invest in an index fund and hold it over the long-term, it is likely that your investment will increase in value over time.
What are 2 cons to investing in index funds? ›
The benefits of index investing include low cost, requires little financial knowledge, convenience, and provides diversification. Disadvantages include the lack of downside protection, no choice in index composition, and it cannot beat the market (by definition).
Is it bad to only invest in the S&P 500? ›
Lack of Global Diversification
The S&P 500 is all US-domiciled companies that over the last ~40 years have accounted for ~50% of all global stocks. By just owning the S&P 500 you miss out on almost half of the global opportunity set which is another ~10,000 public companies.
How can I directly invest in index funds? You can directly invest in index funds by opening and funding a brokerage account. All brokers allow you to directly buy shares of ETFs on the open market, and most allow you to directly invest in mutual funds if you prefer to use those.
Should I invest my 401k in S&P 500? ›
Investing in a broad market index fund can take a lot of the guesswork away. If you're not a confident investor, an S&P 500 index fund could be your best choice. If you're willing to do the work and research stocks individually, you might enjoy stronger gains in your retirement account.
What is the best index fund for beginners? ›
For beginners, the vast array of index funds options can be overwhelming. We recommend Vanguard S&P 500 ETF (VOO) (minimum investment: $1; expense Ratio: 0.03%); Invesco QQQ ETF (QQQ) (minimum investment: NA; expense Ratio: 0.2%); and SPDR Dow Jones Industrial Average ETF Trust (DIA).
What is bad about index funds? ›
While indexes may be low cost and diversified, they prevent seizing opportunities elsewhere. Moreover, indexes do not provide protection from market corrections and crashes when an investor has a lot of exposure to stock index funds.
Do index funds ever fail? ›
While there are few certainties in the financial world, there's virtually no chance that an index fund will ever lose all of its value. One reason for this is that most index funds are highly diversified. They buy and hold identical weights of each stock in an index, such as the S&P 500.
How long should you hold an index fund? ›
Ideally, you should stay invested in equity index funds for the long run, i.e., at least 7 years. That is because investing in any equity instrument for the short-term is fraught with risks. And as we saw, the chances of getting positive returns improve when you give time to your investments.
Can you invest directly into the S&P? ›
You can't directly invest in the index itself, but you can buy individual stocks of S&P 500 companies, or buy a S&P 500 index fund through a mutual fund or ETF. The latter is ideal for beginner investors since they provide broad market exposure and diversification at a low cost.
Can you buy S&P 500 index? ›
The S&P 500 is a stock market index composed of about 500 publicly traded companies. You cannot directly invest in the index itself. You can buy individual stocks of companies in the S&P 500, or buy an S&P 500 index fund or ETF. Index funds typically carry less risk than individual stocks.
Is it safe to only invest in index funds? ›
Lower risk: Because they're diversified, investing in an index fund is lower risk than owning a few individual stocks. That doesn't mean you can't lose money or that they're as safe as a CD, for example, but the index will usually fluctuate a lot less than an individual stock.
Is it wise to only invest in index funds? ›
If you're new to investing, you can absolutely start off by buying index funds alone as you learn more about how to choose the right stocks. But as your knowledge grows, you may want to branch out and add different companies to your portfolio that you feel align well with your personal risk tolerance and goals.
