For buy and hold investors, investing in stock market indexes can be a compelling choice. With their lower fees and expenses, and favorable long-term track record, index investing could be the solution many beginning investors and experienced investors alike are looking for.
Stock Index Definition and Guide
A stock index is a method of tracking the overall movements of the stock market, or a particular market sector or other subset of the market. Common indexes include the Dow Jones Industrial Average, a basket of 30 Large US company’s stock, the S&P 500 Index, an index of 500 large US stocks, and the NASDAQ-100, an index of 100 companies whose stock trades on the NASDAQ stock exchange. The movements of a stock index are calculated by taking the individual movements of each component stock and then applying them in aggregate to the index itself. Exactly how this is calculated varies among the indexes based on whether they are value-weighted, size-weighted, or other methodology.
The indexes themselves are simply mathematical expressions of the movements of individual components. Therefore, investors cannot invest directly in an index since no actual index security exists. The closest thing to investing in an index is to purchase a security which tracks the index the trader is interested in.
Investing in Index Funds
One method of investing in a security that tracks indexes is to buy index funds. Index funds are mutual funds whose objective is not to beat the index they target, but rather to track, as closely as possible, the performance of that index. Like actively managed mutual funds, passive index investing funds are composed of a pool of money from multiple investors that purchased shares in the index fund. The fund manager then uses that pool to purchase securities from the index being tracked.
Most index funds do not purchase all of the stocks in their indexes, except for smaller ones like those that track the Dow 30. Instead, index funds purchase a basket of stocks that are statistically likely to produce returns that are very similar to the index. The result is a mutual fund that behaves very much like the index itself.
Investing in Index ETFs
Index ETFs, like index mutual funds, attempt to replicate the approximate performance of a market index by investing in a basket of stocks that will produce similar returns to the index. Typically, this is accomplished through some kind of trust-type vehicle that makes trades in the index components.
Unlike index mutual funds, ETFs trade on the open market all day long. While a mutual fund can only be purchased and redeemed with the fund manager who calculates the value and executes those trades one time each day, buying and selling occurs always since ETFs trade throughout the day being bought and sold by investors instead of the company that manages the ETF. This allows for lower overall expenses and may make Index ETFs a better option for some investors.
Passive Investing vs Active Investing
Regardless of whether it is through an index ETF or an index mutual fund, passive investing in market indexes typically comes with lower expenses and fees than actively managed mutual funds. Passive investing proponents cite this fact as one of the main advantages of passive investing. They also say that since most actively managed mutual funds do not beat their indexes over long periods of time, there is no value in actively managed mutual funds.
Either way, for buy and hold investors, as well as traders looking to get instant exposure to the broader market, passive index funds and passive index ETFs are an attractive option.