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Indexing Methods in the Stock Market

written by: Brian Nelson•edited by: Michele McDonough•updated: 8/20/2010

An index provides an overview of a specific segment of the market as defined by the creator of the index. Indexes are benchmarks for both individual and professional investors. Investing by indexing can lower costs and taxes, but first you need to understand the indexing methods in the stock market.

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    Stock Market Indexes

    There are thousands of indexes out there. Some are published publicly, while others are kept as proprietary secrets. Either way, chances are that for any particular market segment an investor wants to track or benchmark, there is an index.

    The best known indexes track broad segments of the market. For example, the well-known Standard & Poors 500 index tracks the performance of 500 of the largest U.S. stocks across all industries. Other indexes track smaller segments, such as the S&P 400, which tracks the performance of 400 mid-sized or mid-cap stocks and the Dow Jones U.S. Oil & Gas Index tracks stocks from the oil and gas energy sector.

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    Investing in Stock Market Indexes

    stock-market-index-investing As every prospectus reminds investors, it is not possible to invest directly into any true index. Indexes are, by nature, hypothetical tracking mechanisms that are constructed and tracked on paper only. Indexes incur no trading costs, no taxes, and are adjusted without regard to actual trading volume. In other words, they have no real world costs deducted.

    What indexing methods in the stock market can be used by investors then?

    Fortunately, there are several indexing methods that can be used to invest in an index type of product.

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    Types of Indexing Investment Methods

    Index mutual funds provide the most commonly known method of investing in an index. An index mutual fund invests in certain stocks in a given index as directed in the mutual fund's prospectus. These investments are designed to allow the fund to track the index's performance over time. Unlike the actual index, an index mutual fund must actually trade the stocks in the index and therefore does incur both trading costs and taxes, which are passed through to investors who hold shares of the fund.

    Top index mutual funds are offered by companies like Vanguard, Fidelity, and Charles Schwab, among others.

    Another method of index investing is the Exchange Traded Fund, or ETF, and trust-issued receipts, more commonly known as HOLDRs. An ETF is designed to track a specific index by holding a representative basket of stocks from the index. In this way, ETFs are like Mutual Funds. However, ETFs are traded like stocks on the open market. That means that ETFs can be traded more than once per day, and investors can also short ETF indexes if desired.

    Popular HOLDRs include DIAMONDS and SPDR (SPY) which track the Dow Jones Industrial Average and the S&P 500 respectively.

    Theoretically, an investor could create their own index tracking portfolio by buying and selling individual stocks within an index. However, this is not common. For some indexes, such as the Willshire 5000, simply assembling the necessary number of stocks would be a daunting undertaking. Even small indexes would require dozens of trades to assemble and dozens more each year to keep in line with effects of dividends, stock splits, and index adjustments.

    Finally, advanced investors can use Index options to gain exposure to various market indexes. There are options on ETFs available, as well as specifically construction options such as those offered by the Chicago Board of Exchange (CBOE). Buying LEAPS allows for long-term investing via options. Options have the benefit of leverage for advanced investors and also provide for a limited downside when used properly.

    For most investors choosing an index fund or ETF are the best indexing methods. These methods are easy to execute and track and do not require continuous monitoring for drifting off of the index or reinvesting of dividends or other handling other adjustments.