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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.[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 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.[note 1]

Index strategy boxes

Benchmark Index Strategy Box.png
Benchmark Index Strategy Box[2]

Equity and fixed income (bond fund) style boxes provide the investor with insight regarding 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 cannot adequately represent the diverse selection criteria for index funds.

In place of investment styles, index funds are categorized according to the methodology ("rules") used for investment selection. This index fund selection strategy can be categorized using security selection and security weighting rules. Similar to the style boxes for risk vs. return, a 3 x 3 grid is used to categorize index fund strategies using selection vs. weighting.

The only commonality between investment style and index strategy boxes is an easy to understand 3 x 3 grid designed to help make investment decisions. There is no relation between them otherwise.

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

Index strategy box background and category breakdown are described in Indexing in the 21st Century: Portfolio Solutions Inc..

Index characteristics

According to the CFA Institute, 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

Main article: Index fund

An index fund manager attempts to capture market returns by employing a number of management techniques. These include replicating or sampling the index universe[note 2] of securities, equitizing cash balances to remain 100 percent invested, and by employing trading strategies that minimize transaction costs.


Index funds tracking 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 stands 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.[5]


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." [6]

Sometimes this is called Physical replication with optimization: Optimization methods are model-driven, with a computer system making the buy and sell decisions. The ETF manager may use the physical replication with optimization if the index being tracked contains too many securities, and the ETF manager would like to reduce transaction costs.

Swap-based replication

Certain funds perform replication of the index using derivatives as opposed to owning the physical assets, these are often called synthetic ETFs.


In order to reduce tracking error to its underlying index, index fund managers attempt to remain fully invested. Almost all mutual funds hold a cash balance, primarily to meet potential fund redemptions by fund investors.

This holding of cash will be a drag[note 3] on fund returns during any period when stock returns outpace cash returns. Mutual funds hold cash as a result of shareholder cash flows into the fund (before the manager can purchase securities), as a holding from which to pay shareholder redemption of shares, and for active funds, a usual holding when the manager can not find securities of appealing valuation. Mutual funds tend to average 4 to 6 percent cash in their fund portfolios.[note 4]

The index manager reduces the tracking error of holding cash balances by buying a futures contract, or sometimes an exchange-traded fund (ETF), with the cash holdings. Since a futures contract is leveraged, an index manager can get an index return on a cash balance while waiting to efficiently invest a cash inflow directly into stocks, or to remain liquid in order to meet redemption of fund shares. Here is a simplified example.

  1. The index manager has a $500,000 cash balance.
  2. The index manager buys an index futures contract placing a $25,000 cash deposit for holding a $500,000 index futures position.
  3. The index manager now receives the index return on the futures ($500,000 worth assuming the futures track the index) while maintaining $475,000 cash liquidity from which to meet shareholder redemption requests.

This procedure is known as equitizing cash.

In another example, a manager might place a $10,000 margin deposit on a futures contract valued at $450,000. The manager can then place the remaining $440,000 into a short term interest paying account and still retain full market exposure from the $450,000 futures position.[7]

See also


  1. This page primarily concerns traditional market capitalization indexing. Indexes have been developed based on alternate weighting methodologies. See Alternate Indexes for an examination of these indexes.
  2. A set of securities that shares a common feature such as the same market capitalization, industry or index. Universe Of Securities, from Investopedia
  3. "Cash drag" is used to describe an additional "cost" hurdle that an active manager must exceed in order to beat a benchmark return. For an index manager, cash holdings will increase tracking error to the index.
  4. The latest number can be found at ICI - Monthly Trends in Mutual Fund Investing


  1. Richard A. Ferri, All About Index Funds, pp. 10-11.ISBN 0-07-148492-2
  2. Indexing in the 21st Century: Portfolio Solutions Inc.
  3. Buying The Market Isn’t As Simple As It Seems, forum discussion.
  4. Richard A. Ferri, All About Index Funds, Chapter 6. ISBN 0-07-148492-2
  5. W. Scott Simon, Index Mutual Funds, p. 139. ISBN 0-9661172-7-1
  6. W. Scott Simon, Index Mutual Funds, pp. 139-140. ISBN 0-9661172-7-1
  7. W. Scott Simon, Index Mutual Funds, pp. 144-145. ISBN 0-9661172-7-1

External links