“In order to understand index investing, it is first necessary to understand just what is an index and, how and why to invest in an index or indexes.”

What is an Index?

When we hear the nightly news declare that the ‘market’ was up X% or down Y% today, the reporter is usually referring to the market as observed through the movement of a representative index. For example, in the Australian market, the dominant index reported may by the Standard and Poors ASX 200 index (S&P/ASX200).

So in reality, the reporter is commenting on the movement of the market as reflected in the movement of this index, which in turn represents the movement of the share price of the 200 largest (as measured by their market capitalisation) companies or securities. In effect, the index becomes a proxy for the performance of the overall market place for that trading period.

How do I use the Index?

Here are some simplistic examples of using index based investments.

Given the obvious challenge of tracking, monitoring and evaluating each individual security in a market, bundling the securities into a unit of measure called an index provides an extraordinarily efficient way of viewing the market as a whole. In addition, this approach provides an opportunity to view market sectors, both domestic and global, along with individual economies or countries and regions or the global economy as a whole.

An Index Fund, then is a managed fund based on an index and mirrors the performance of that index. The index fund can be listed on a stock exchange (Exchange Traded Funds – ETFs) for quick and easy transacting, or remain unlisted just like most managed funds.

For example, if your view of the Australian securities market is that it should expand in value over the next period of time, you can purchase the ASX listed security STW which tracks the S&P/ASX200 movement and also pays the average dividend income of the market. Should you have the view that European markets are expected to perform over a period you may purchase the security IEU which provides broad exposure to the index reflecting the movement of the largest 350 securities on Euro markets. Should you believe that resource markets are expected to perform strongly over a period you can purchase index securities representing the materials or energy elements of global markets.

Index funds are available over all asset classes including global and domestic shares, property, fixed income, currency, commodities and strategies mixing these classes.

In addition, a range of products are available utilizing financial engineering to achieve specific outcomes such as enhanced income and enhanced capital growth. These products may incorporate the use of derivative instruments (such as Options and Futures, Swaps, CFDs, etc) and may also include leverage.

IndexInvest is a specialist analyst and manager of index based investments.

Index Investing Basics: Read more