Indexing is the use of some kind of benchmark or measure. In finance and economics, indexing is considered as a measure of monitoring of economic indicators (inflation, unemployment, GDP growth, productivity and profitability from the market).
Indexing can be classified as a passive investment strategy that replicates benchmark indices. Index investing is becoming more and more popular.
Indexing helps to observe changes in economic data. Economic indexes are some of the main indicators of economic trends in the marketplace. The following economic indexes are monitored to assess changes over time in financial markets:
- PMI - Purchasing Managers' Index.
- ISM - Institute for Supply Management manufacturing index.
- Complex Index of leading economic indicators.
Statistical indexes can also be used as a meter for adjusting values. The CPI (Consumer Price Index) indexes prices according to inflation. By analyzing the CPI, a statistical COLA (Cost Of Living Adjustment) can be obtained. Retirement and insurance policies use indexation measures, COLAs, and CPIs to adjust pensions for inflation.
Indexing in financial markets
An index is a way of tracking the asset group indicators. An index represents indicators of a security set in a particular market sector. An index can cover the whole market or a certain industry or sector. The Dow Jones Industrial Average is a price index (stocks with higher prices are more valuable). The S&P 500 Index is a market capitalization index (it has greater stock values with a greater market capitalization).
There are many methodologies for calculating investment market indexes. These indexes serve as efficiency benchmarks for any market participants. They will not participate in a fund that is behind the S&P 500 index in the long-term.
There are also indexes for the bond, commodity and derivatives markets.
Indexing and passive investing
Indexing is used to influence a certain market segment. It is a passive investment strategy. Investing in a target market segment for capital income or for a long-term investment causes many costs (trading costs for the purchase of individual securities). That’s why many investors use indexing, since the most active investment managers generally cannot outperform indexes.
A person can get the same target index risk and profitability by investing in an index fund. A lot of index funds have small expense coefficients. They work effectively in a passive management portfolio. Index funds can be based on personal stocks and bonds to replicate target indexes. They can also be a fund of funds based on mutual funds or exchange-traded funds.
Index funds have lower management fees and expense ratios (ERs) compared with active management funds (index investing uses passive management). Providers charge lower fees, because there is no need for a portfolio manager. Market monitoring is simple. From a tax payment aspect, index funds are more efficient than funds under permanent control, because deals are infrequent.
Indexing and tracker funds
It's very difficult to replicate the composition and profitability of an individual index. This requires other indexing strategies. Index tracking funds are unexpensive option for investing in a specific set of individual securities. These tracking funds are into selecting the best of the best categories of securities (the best companies in tracking indexes). Selection is based on a number of specific indicators (dividends, growth characteristics, etc.).