Indexing

Indexing is an investment management strategy that attempts to replicate the investment performance of a market index. An index is a statistical measure of a market's value and performance and serves as a benchmark against which an investment manager's performance is judged. . Today, a a large number of index providers, including S&P, Dow Jones, MSCI, Russell, FTSE, and Morningstar, provide a wide range of indexes covering  US and  International stocks,  bonds, and commodities. A well managed, low cost index fund offers investors an excellent, if not optimal, investment vehicle for investing in the overall stock market, in discrete market segments, in the bond markets, and  in the commodity markets.

Structure
An index fund manager attempts to capture market returns by employing a number of management techniques. These include replicating or sampling the index universe of securities, equitizing cash balances to remain 100 percent invested, and by employing trading strategies that minimize transaction costs.

Replication
Indexes measuring large size and mid size companies usually buy and hold all of the stocks comprising a large cap or mid cap index. These stocks are held proportionally in the percentage weight a stock's market value measures in comparison to the market value of the index. Thus if Exxon Corp. has a value representing 3% of the index, an index fund replicating the index would hold a 3% weighting of Exxon in the fund. A replicated index fund should provide an expected return mirroring its index, reduced by the costs of managing the fund and the costs of transacting asset purchases and sales.

Sampling
Indexes which comprise a large number of small illiquid companies or illiquid bonds often make it very costly to fully replicate the index. Thus many small and micro cap index funds, as well as many bond index funds, sample their universe of securities. The sampling attempts to match the size and valuation metrics of the index. Because a sampled index fund does not hold all of the securities in the underlying index, its returns may vary somewhat from those of the index. Such performance variance is termed "sampling error."