What is Index Investing?

What is Index Investing?

Index investing is a passive investment technique that attempts to generate returns similar to a broad market index. Investors use this buy-and-hold strategy to replicate the performance of a specific index—generally an equity or fixed-income index—by purchasing the component securities of the index, or investing in an index mutual fund or exchange traded fund (ETF) that itself closely tracks the underlying index.

There are several advantages of index investing. For one, empirical research finds index investing tends to outperform active management over a long time frame. Taking a hands-off approach to investing eliminates many of the biases and uncertainties that arise in a stock-picking strategy.

Index investing, as well as other passive strategies, may be contrasted with active investment.

How to Start Index Investing

Step 1

The first step to index investing is choosing the right index for your preferences. As mentioned, a common index to track is the S&P 500, an index composed of 500 large U.S. companies. Other popular indexes include the Dow Jones Industrial Average (DJIA), a composite of 30 US large-cap companies, and the NASDAQ Composite, another U.S.-based index that is heavily weighted in the IT sector. The U.S. market is often used synonymously as the broad market because of its importance and influence as a financial hub.

For individuals with more advanced financial knowledge, index investing can be a very useful tool to potentially “beat the market.” If you expect a particular region, sector, or factor to outperform, you can choose to invest in an index that specializes in such areas. For example, if you expect Asia to outperform in the future, you may look into tracking an Asian index. Popular indexes include:

  • Shanghai SE Composite Index (China)
  • Hang Seng Index (Hong Kong)
  • Nikkei 225 (Japan)
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The stock market is comprised of 11 sectors, formally known as the Global Industry Classification Standard (GICS). Such sectors include IT, healthcare, consumer discretionary, energy, industrials, and more. There are many available sector indexes that can be benchmarked.

Lastly, a factor is an attribute that’s been historically proven to provide excess returns across assets. Some identified factors include:

  • Value
  • Size
  • Quality
  • Momentum
  • Volatility
  • Growth

Each factor performs well at different points in the business cycle. If you feel confident of any specific factor, you can target it by buying into a factor index.

Of course, it should be noted that investing in a specific area will increase your risk. It is because if you choose to go overweight in a specific region/sector/factor and it ends up doing poorly, all your investments will suffer as a result. Nevertheless, higher risk comes with a higher return, so if you bet on a specific area that performs favorably, you can beat the broad market.

Step 2

The second step is to choose a fund that tracks such an index. There are many ETF providers that will have similar offerings with slight variations, so it is wise to do research into the differences. Such differences could be the expense ratio, dividend yield, performance, and more.

Step 3

The last step is to buy shares from your chosen index fund. To do so, you must open an account through a broker. Again, every broker may offer different benefits and drawbacks, so it is important to compare before jumping in.

Limitations of Index Investing

Despite gaining immense popularity in recent years, there are some limitations to index investing. Many index funds are formed on a market capitalization basis, meaning the top holdings have an outsized weight on broad market movements.

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So, if, say, giants such as Amazon.com Inc. (AMZN) and Meta Platforms Inc. (META), formerly Facebook Inc., experience a weak quarter it would have a noticeable impact on the entire index.

This entirely passive strategy neglects a subset of the investment universe focused on market factors such as value, momentum, and quality. These factors now constitute a corner of investing called smart-beta, which attempts to deliver better risk-adjusted returns than a market-cap-weighted index.

Smart-beta funds offer the same benefits of a passive strategy, with the additional upside of active management, otherwise known as alpha.

Advantages of Index Investing

Warren Buffet once said, “A low-cost index fund is the most sensible equity investment for the great majority of investors,” and it’s clear to see why.

  • Low cost: Because index funds take a passive approach tracking an index, it has lower management fees than an actively managed fund
  • Requires little financial knowledge: Index investing is relatively easy compared to building your own portfolio
  • Convenience: Index funds contain hundreds of stocks that would be incredibly hard to replicate at an individual level
  • Diversification: Holding a large array of stocks diversifies away idiosyncratic (firm-specific) risk

Disadvantages of Index Investing

Lack of downside protection: There is no floor to losses

  • No choice in the index fund’s composition: Cannot add or remove any holdings
  • Can’t beat the market: Can only achieve market returns (generally)