What Is a Stock Index?
A stock index is a compilation of stocks constructed in such a manner to replicate a particular market, sector, commodity, currency, bond, or anything else an investor might want to track. Indexes can be broad or narrow. For example, the NASDAQ Composite tracks thousands of common stocks and similar securities that are traded on the Nasdaq stock exchange. The more specified Nasdaq 100 Index (NDX) is an index that tracks the largest 100 non-financial companies listed on the NASDAQ Composite.
Keep reading for a further explanation of how indexes track markets, as well as ways that investors can use them to build a portfolio.
How an Index Works
The underlying holdings in an index are commonly referred to as the index's "basket of stocks." For example, the Dow Jones Industrial Average Index (DJIA) includes 30 of the largest U.S. companies.
These indexes act as guidelines for investors trying to replicate a particular asset, market, or region. An investor who wants to add exposure to large-cap U.S. stocks can use the Dow as a guide for which stocks to pick.
Similarly, the Philadelphia Gold and Silver Index (XAU) consists of companies that mine gold and other precious metals. If you buy the stocks in the index, you will gain balanced 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.
Alternatives to Replicating Indexes in Your Portfolio
While you can individually buy all the stocks in an index, there's an easier way to add index exposure.
Mutual funds and exchange-traded funds (ETFs) track indexes. These products essentially lower the barriers to entry to buying these indexes. Rather than saving up the money needed to buy one share of every stock listed on an index, an investor can obtain the same diversification by buying shares in a mutual fund or ETF that tracks that index.
Fees are the primary drawback to mutual funds and ETFs. A fund manager ensures that the underlying stocks replicate the index being tracked, so investors pay fees to compensate the manager.
While ETFs, like any investment, come with certain disadvantages, they've become incredibly popular. In 2019, ETF assets under management topped $4 trillion. Many investors find that the advantages of ETFs outweigh the drawbacks. For example, ETFs enjoy certain tax advantages over the mutual funds that track the same index.
Index-weighting refers to the method of how the shares in an index basket are allocated. In other words, an index's weighting is how the index is designed. For example, a price-weighted index buys shares in proportion to the cost of those shares. A stock worth $20 might have one share included in the index, whereas a stock worth $5 would have four shares included.
The most popular type of weighting is based on market capitalization. The shares of each stock in a cap-weighted index are based on the total market value of the company's outstanding shares. Put simply, this means the index includes more shares of companies that are worth more, and fewer shares of smaller companies.
Other possible methods of weighting include revenue-weighted indexes, fundamentally-weighted indexes, and float-adjusted indexes.
Advantages of Buying an Index
Indexes are a nice way to gain exposure to certain markets or sectors without having to place thousands of orders. It's cheaper and simpler than doing the research and placing the orders to replicate a sector on your own.
Depending on the sector being tracked by the index, buying indexes may be the only option for an average investor looking to expose themselves to certain markets. For example, not everyone has the space to store barrels of oil, herds of cattle, or bags of wheat. Instead, these investors can buy the appropriate commodity index that tracks the market they want to buy into.
Disadvantages of Buying an Index
While an index is designed to emulate a certain market, that doesn’t mean it’s 100% accurate. Just because you buy a foreign market index in a certain region, that doesn’t mean your basket will perfectly reflect the economy of that region. Many factors can alter the course of an economy, and sometimes it's difficult for an index to accurately account for all of those factors.
Not all indexes are liquid. It may be difficult to trade in and out of certain positions, depending on the index you track. Then again, the same thing can be said for certain securities, as well.
In fact, all the downsides that come with other forms of investing also apply to index investing. That includes issues related to order type—market orders will execute quickly but they won't guarantee a price, while limit orders control the price at the cost of timeliness.