What Is an Index?

An index, by its definition, provides an indicator or measure of something. In the investment world, it’s a statistical tool that tracks the performance of an asset class or a sector of an asset class. Today, there are indexes for nearly all aspects of the capital markets.

At a high level, indexes typically fit into one of a handful of broad personal finance categories, including stocks, bonds, real estate and commodities, but these categories can be segmented into much narrower niches. A handful of the better known indexes, all of which track publicly-traded securities, are outlined below.

An index is a statistical tool that helps economists, investors and businesspeople speak the same financial language. But how is the tool actually used by investors? Essentially, there are three main applications of indexes.

The most common usage of an index is to monitor market performance and gauge economic sentiment. For instance, the S&P 500 index, which represents approximately 80 percent of U.S. publicly traded stocks, is a very sound measure of domestic stock market performance and economic sentiment. Individuals and organizations all over the world monitor this index to get a quick indication of how things are going in the U.S.

Beyond monitoring the market at a high level, many investors use indexes to gauge the performance of specific investments. For example, an active investor in the U.S. stock market can use the S&P 500 index to evaluate whether he or she is performing favorably or unfavorably to the broader market. Favorable relative performance is indicative of shrewd decision-making, while underperformance is indicative of suboptimal trading and poor market timing.

Performance benchmarking is especially important when evaluating the performance of actively managed mutual funds and other investment vehicles. Here, benchmarking gives investors the ability to determine whether investment managers, who can be very expensive, are performing well.

Arguably the most beneficial application of an index is index-linked investing — commonly referred to as passive investing. It is a widely popular and low-cost way to replicate the returns of an index rather than trying to outperform it.

Index-linked investing happens when an investment fund or strategy is established with positions that mirror an index. For example, the Dow Jones Industrial Average (DJIA) is replicated by buying proportionate positions in the 30 companies in the DJIA and maintaining the appropriate proportions over time. Essentially, this means buying more of the stock of outperforming companies and selling more of the stock of underperforming companies.

Investment companies recognized the merits of index-linked investing several decades ago. Since then, a myriad of index funds and ETFs have emerged, providing access to virtually every market and market sector in the world. Nevertheless, the number of indexes is continually increasing, largely because there is an insatiable appetite for new ways to invest in capital markets.

Index-linked investing is not only associated with index funds and ETFs. It is a prominent feature of indexed annuities, which are financial contracts issued by insurance companies to individuals looking to save for retirement. The typical indexed annuity works as follows:

In exchange for an upfront payment, the insurer provides the individual — or annuitant — a guaranteed stream of future income, with the opportunity to increase future payouts based on the performance of a stated index such as the MSCI ACWI. When the index performs well, the future income stream grows (up to stated limits), but the value of the annuity never declines.

As such, indexed annuities provide retirement savers the chance to share in market gains while limiting their downside risk.