Stock market indices like the US’s S&P 500 or the UK’s FTSE 100 represent a crucial part of investing. That’s because they serve as financial measures that present the changing wealth of a particular set of stocks and shares, bonds, or other securities.
In addition to helping investors know how a market is performing, indices create index tracker funds which are a vital part of retail investment vehicles.
Here’s more information about stock market indices and how index trackers work.
Stock Market Index Explained
A stock market index helps investors monitor changes in the price of a basket of securities. By securities, we mean stocks, bonds, and commodities like oil, precious metals, and agricultural products.
Indices keep investors updated on the market’s daily and annual performance. They also allow investors to compare the performances of different markets worldwide.
Understanding a Stock Market Index
Stock indices, such as the S&P 500, are created to gauge the characteristics and performance of certain markets or asset classes. Such indices are usually weighted by the market capitalization (market cap) of specific constituent companies or securities.
For example, a firm worth $20 billion would have twice the weighting in an index of a company with a market cap of $10 billion.
The market cap is determined by multiplying the company’s current share price by the total number of shares outstanding or shares in issue.
Having weighted every firm in an index, the combined market cap of all the shares is then calculated regularly, providing the index’s total value and letting investors observe changes in its performance in the long run.
The Importance of Stock Indices
Indices provide investors with an overview of the performance of a particular market without examining the performance of the companies included in it. In addition, they are crucial for measuring an investment’s performance.
For instance, active funds, which involve the skills and expertise of a fund manager in choosing investments that the fund will hold, are typically assessed by their ability to outperform a certain benchmark by a specific amount.
The benchmark is often a stock market index. If a fund is aiming a percentage point higher than the S&P 500 index, that means the manager seeks the same return as the index, plus 1%.
Stock Indices and Passive Investing
Indices are also key to passive investing, which provides access to a range of securities, usually at a reasonable cost. The goal of passive investing is to copy or follow the return generated by a specific stock market index or benchmark via computers to sustain a stock portfolio that tracks the index.
That could mean copying the performance of the S&P 500 or other stock indices.
The number of passive fund managers has increased in recent years, as only a few active managers have successfully turned a record profit over time.
Considering many active funds cannot keep up with the performances of their benchmarks, the oracle of Omaha, Warren Buffett, has described index funds as making “the most sense practically all of the time”.
If you plan to participate in passive investing, retail investors recommend index trackers and exchange-traded funds (ETFs) as the top two products to go for.
Index-Tracking Funds Explained
Index trackers are collective investments, meaning the funds have been pooled from several investors into one place.
Investors allocate money into an index tracker to invest in all the companies in a certain index. That gives investors more diversity in their portfolios than purchasing a focused handful of stocks.
Some index trackers use full replication, which is holding all the stocks in an index. Other funds choose optimized sampling to make an index’s profile without buying all the underlying stocks.
To assess an index fund’s performance, you can look at the tracking error. That shows how much an index fund’s performance has strayed from the index or benchmark it is following. It is measured in percentage; therefore, a 0% tracking error means it replicates perfectly.
Index trackers are typically created as open-ended investment companies (OEICs), while others are built as unit trusts. The feature that those two types of funds share is being open-ended, meaning each can offer a potentially unlimited supply of shares or units.
If you’re investing in a tracker fund, you can only expect to replicate the performance of a specific index. Furthermore, keep in mind that your investments are likely to lose or gain over the long term when monitoring the gains of a particular index.
Investing in Index-Tracking Funds
You can invest in index-tracking funds through an online investing platform or mobile trading apps. Seeking the expertise of a financial advisor or a semi-automated robo-advisor are also a popular option.
In addition, an individual savings account (ISA) can help you buy index trackers tax-efficiently.
Still, remember that every index-tracking fund is different. Some cost less than others, while some funds are more precise in copying an index’s performance. But overall, passive investments are often more low-cost than active investments.
Whether an index tracker uses full or partial replication, such an index fund is cheaper than working with active managers and their support teams.
However, an annual fee is still involved in covering a tracker fund’s costs. You may also need to pay a transaction fee for buying or selling an index tracker. That is why you should compare trading platforms for their conditions because there could be huge differences between providers.
An ISA provides a tax-efficient way to own an index-tracking fund, as investments kept in such a product are not subject to capital gains and income tax.
Still, particular charges can weaken an investment’s ability to generate profit. Therefore it’s important that you use a service that can meet your investing needs without costing too much and is in line with your other requirements, such as a suitable choice of funds.
The Risk of Index-Tracking Funds
Any investing that involves the stock market has risk. An index fund with multiple shares has more diversity than a portfolio holding a few securities.
In a stock index fund, every firm in that fund would need to underperform first before you lose everything. However, depending on the fund’s focus, an index fund could fare poorly and lose for some years if, for example, a sector or investment region loses investors’ confidence.