A stock index is a compilation of stocks constructed in such a manor to track a particular market, sector, commodity, currency, bond, or other asset. For example, the NDX is an index that tracks the largest 100 non-financial companies listed on the NASDAQ.
What is in an Index?
The stocks in and index are collected in what’s known as a basket. For example, if you wanted to invest in the Dow Jones Industrial Average Index (DIJA), you would purchase shares of the 30 stocks in the index basket. You would actually own shares of 30 different companies.
How Does an Index Work?
Indexes are designed to track a particular market or asset. For example, the Gold and Precious Metals Index (XAU) consists of companies that mine gold and other precious metals. The logic is that if you buy the stocks in the index, you will gain exposure to the gold mining sector without having to buy shares in every single gold mining company in the world. The shares in the XAU are representative of the gold mining industry as a whole.
What Does Index-Weighting Mean?
Index-weighting is how the shares in an index basket are allocated; basically how the index is designed. For example, a price-weighted index has different amounts of shares for each stock based on price. A stock worth $20 would have 1 share, where a stock worth $5 would have 4 shares to make it equal to the $20 stock.
Another type of weighting is based on market capitalization. The shares of each stock in a cap-weighted index are based on the market value of the outstanding shares. There are also revenue-weighted indexes, fundamentally-weighted indexes and even float-adjusted indexes.
What are the Advantages of Buying an Index?
Indexes are a nice way to gain exposure to certain markets or sectors without having to corner the market in stocks. It’s easier to buy a commodity index instead of buying barrels of oil, some cattle, and a few bags of wheat. You can gain exposure to the overall performance of a market buy buying the appropriate index basket.
What are the Disadvantages of Buying an Index?
While an index is designed to emulate a certain market, it doesn’t mean it’s 100% accurate. Just because you buy a foreign market index in a certain region doesn’t mean your basket will move exactly with the economy of that region. There are many factors can alter the course of a market that sometimes an index can’t reflect, at least not immediately.
Filling a basket order is not always the easiest process either. While it is easier to buy an index than 4,000 industry stocks, that doesn’t mean you always get your target price. If you use market orders, you will eventually fill your basket, but you may not get the desired price. Or if you use limit orders, you may not get all the shares needed to fill the basket.
And not all indexes are liquid. Meaning it may be difficult to trade in and out of certain index positions. Then again, the same thing can be said for certain securities as well.
Is there an Alternative to Indexes?
Of course…ETFs. (Somehow you knew I would mention exchange traded funds) The nice thing about ETFs is that they are constructed to mimic an index, much like an index is designed to mimic other markets and assets. However, in the case of an ETF, the “basket” is pre-packaged and ready for trade. You don’t have to make 11 buy transactions to get the stocks in a certain index, instead you make one purchase of an ETF, which is a collection of the 14 stocks in one asset; a mini-portfolio if you will.
There are many advantages ETFs hold over indexes like tax advantages and ease of trade, however ETFs have their share of disadvantages, too. But ETFs have come a long way and their benefits have made them suitable replacements for many investments like mutual funds and indexes. So if you think ETFs may be an alternative to index investing, you’ve come to the right place.