From Bogleheads

Indexing is an investing strategy that aims to match the 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.[1] Today, 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 gives you 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.

This page primarily looks at traditional market capitalization indexing. There are indexes based on alternate weighting methodologies. For more, see: Alternate Indexes.

Index strategy boxes

Figure 1. Benchmark index strategy box[2]

Equity and fixed income (bond fund) style boxes give you an idea of risk versus return. The equity style box is based on market capitalization, while the fixed income style box is based on investment grade quality. These investment styles are not enough to cover all the selection criteria for index funds.

Instead of investment styles, index funds are categorized according to the way they select investments, using security selection and security weighting rules. Similar to the style boxes for risk vs. return, a 3 x 3 grid categorizes index fund strategies using selection vs. weighting.

The only thing investment style and index strategy boxes have in common is an easy to understand 3 x 3 grid, designed to help make investment decisions. They are otherwise unrelated.

For example, benchmark indexes are in the passively managed, market capitalization security weighted segment of the Index Strategy Box.[3]

For background on index strategy box background and category breakdown, see Indexing in the 21st Century, from Portfolio Solutions Inc.

Index characteristics

According to the CFA Institute, a securities 'index' should have the following characteristics:[4]

  • Simple and objective selection criteria: There should be a clear set of rules governing the inclusion of bonds, equities, or markets in an index, and investors should be able to forecast and agree on changes in composition of the securities in an index.
  • Comprehensive: The index should include all opportunities that are realistically available to be purchased by all market participants under normal market conditions. Both new and existing securities should have frequent pricing available so the index level can be accurately measured.
  • Replicable: The total returns reported for an index should be replicable by market participants. Over time, an index must represent a realistic baseline strategy that a passive investor could have followed. Accordingly, information about index composition and historical returns should be readily available. It must also be fair to investment managers who are measured against it, and to sponsors who pay fees or award management assignments based on performance relative to it.
  • Stability: The index should not change composition frequently, and all changes should be easily understood and highly predictable. The index should not be subject to opinions about which bonds or equities to include on any particular day. Conversely, index composition is expected to change occasionally to ensure that it accurately reflects the structure of the market. A key virtue of an index is to provide a passive benchmark. As such, investors should not be forced to execute a significant number of transactions just to keep pace.
  • Relevance: The index should be relevant to investors. At a minimum, it should track those markets and market segments of most interest to investors.
  • Barriers to entry: The markets or market segments included in an index should not contain significant barriers to entry. This guideline is especially applicable to an international index in which an included country may discourage foreign ownership of its bonds or participation in its equity market.
  • Expenses: In the normal course of investing, expenses related to withholding tax, safekeeping, and transactions are incurred. For a market or market segment to be included, these ancillary expenses should be well understood by market participants and should not be excessive. For example, if expenses are unpredictable or inconsistently applied, an index cannot hope to fairly measure market performance.

Index fund structure

An index fund manager uses several management techniques to try to capture market returns. These include replicating or sampling the index universe of securities, equitizing cash balances to remain 100 percent invested, and trading strategies that minimize transaction costs.

  • Replication: Index funds tracking large size and mid size companies usually buy and hold all of the stocks of the index.
  • Sampling: For indexes which comprise illiquid securities, funds will sample their universe of securities to avoid high costs. Sometimes this is called Physical replication with optimization. The sampling attempts to match the size and valuation metrics of the index.
  • Swap-based replication or synthetic ETFs: Certain funds perform replication of the index using derivatives as opposed to owning the physical assets.
  • Equitization: The index manager reduces the tracking error of holding cash balances by buying a futures contract with the cash holdings to avoid the cash drag.

See also


  1. Rick Ferri. All About Index Funds. pp. 10–11. ISBN 0-07-148492-2.
  2. "Indexing in the 21st Century". Portfolio Solutions Inc. Archived from the original on December 30, 2011.
  3. Bogleheads forum post: "Buying The Market Isn’t As Simple As It Seems". October 7, 2010.
  4. Rick Ferri. "Chapter 6". All About Index Funds. ISBN 0-07-148492-2.

External links