What Is an Index: A Complete Guide

Indexes are robust, efficient, and reliable tools for assessing investment performance, reflecting risk profiles, and forecasting potential asset returns.

So, what are indexes? What is the index used for? By the end of this article, you'll understand everything you need to know about indexes, including their definitions, use cases, and the most common examples.

What Is an Index?

A financial index serves as a reference mark for analyzing markets, measuring the price performance of a basket of securities, tracking investment performance, and making comparisons across different investments. In essence, it acts as a benchmark for evaluating the effectiveness of investments.

The primary index’s purpose is to track asset performance through a price-based assessment. Indexes measure how a group of securities performs over time — they can be broad, tracking the entire market, or specialized to measure specific market segments.

Understanding Indexes

Indexes are powerful and efficient benchmarks that allow investors to determine the performance of a particular strategy or portfolio. They allow investors to compare a fund or strategy against a standard to assess its actual real performance.

So, what does the index do? Instead of analyzing each asset individually, an index provides a consolidated view of a market segment, offering insights into overall trends. This makes it easier for investors to understand sector-wide movements without tracking hundreds of individual stock prices.

Financial indexes primarily track asset prices. However, there are also separate specialized indexes, such as the Consumer Price Index (CPI) for inflation or bond indexes for interest rate movements, that monitor broader economic data like inflation and interest rates.

Fund managers often use indexes as performance benchmarks and as templates for building index-based investment products. The calculation method of an index depends on its type: price-weighted indexes (e.g., the DJIA) sum stock prices and divide by a specific divisor, while market-cap-weighted indexes (e.g., the S&P 500) weight companies according to their market capitalization.

Index Investing

When discussing index usage, one major application is serving as a benchmark for evaluating the performance of mutual funds and exchange-traded funds (ETFs). For example, a mutual fund might compare its returns to the S&P 500 to illustrate investors how its active management performs relative to a passive strategy.

Indexing is a form of passive fund management. Instead of selecting individual stocks to invest in and creating a custom investment strategy, fund managers construct portfolios that mirror the holdings of a specific index. The point behind this strategy is that by replicating the index profile, the fund will achieve similar performance.

Because you can't invest in an index directly, index funds are created to mimic index performance. How does this work in practice? The funds hold securities that are, in fact, mirror those in the index. This allows investors to invest in the overall performance of the index — typically for a lower fee than actively managed funds.

By using mutual funds and ETFs, fund providers try to build portfolios that reflect the composition of particular indexes. This strategy allows investors to align their portfolios with market movements, whether for the entire stock market or specific sectors.

Examples of Indexes

There are thousands of different indexes in the stock market. Let’s look at those that are the most common and widely used.

• The S&P 500: This example of an index is one of the most famous indexes in the world. It measures the performance of approximately 500 leading publicly traded US companies and is weighted by free-float market capitalization.
• The Dow Jones Industrial Average: Unlike the broader S&P 500, this index has a narrower scope — it monitors the performance of 30 American businesses. The DJIA is a price-weighted index.
• The Nasdaq 100: This index tracks the performance of the 100 largest and most actively traded non-financial companies on the Nasdaq exchange, with a strong emphasis on the technology sector. It is based on market capitalization.
• NASDAQ Composite: It is a broad index that includes all stocks listed on the Nasdaq Stock Exchange (over 3,000 companies) and is also weighted by market capitalization.
• Russell 2000 Index: This index focuses on roughly 2,000 small-cap US public companies, selected as the smaller members of the Russell 3000 Index. It is also market-cap weighted.
•  Wilshire 5000 Total Market Index: A comprehensive capitalization-weighted index that aims to capture the performance of the entire US stock market.

Final Thoughts

Financial indexes are an efficient and reliable way to evaluate broad sections of the market without tracking every individual asset. They are used both globally and within specific market segments to help investors understand financial trends and performance. In a broad sense, indexes show the situation in financial markets and help investors evaluate the performance of their segments. Indexes also serve as benchmarks, providing reference points for comparing performance and building passive investment strategies. Whether you're managing a portfolio or analyzing market trends, understanding indexes is essential for making informed investment decisions.