Indexing is an investment management strategy that attempts to replicate the investment performance of a market index. There are a number of stock market index and bond market index providers who have created indexes using a variety of methodologies and covering a wide variety of asset classes. An index is a mathematical construct, so it may not be invested in directly. Most index providers strive to provide investable indexes, so that the index can serve as a benchmark.
An indexed investment strategy such as an index fund or an index-based exchange-traded fund (ETF) seeks to track the performance of an index by assembling a portfolio that invests in the same group of securities, or a sampling of the securities, that compose the index.
An index is a method of measuring the value of a section of a capital market, such as stocks and bonds. It is computed from the prices of selected marketable securities of the given market, market segment or asset class.
The value of an index is calculated on a regular basis using either the actual or estimated market prices of the individual securities, known as constituent securities, within the index.
Index providers make choices when creating an index. These choices typically include:
- the target market to represent
- which securities should be selected
- how much weight should be allocated to each security. Choices include equal weighted, fundamentally weighted, market capitalization weighted, or price weighted.
- when should the index be rebalanced
- when should the security selection and weighting decision be reviewed
Indexes are used to gauge market sentiment, benchmarks for actively managed portfolios and the underlying portfolios for investment products such as index funds and ETFs.
There are a number of considerations when selecting an index fund or ETF. As indexing products have gained in popularity, index providers have responded by creating a wide variety of indexes that can be used.
Most indexes are market value weighted, also known as capitalization-weighted. This approach may overweight over valued stocks and underweight under valued stocks. Fundamentally based indexes are relatively new and provides weighting by a combination of fundamental factors such as sales, book value, dividends, and earnings. Although thoroughly back tested over many countries and time periods, it remains to be seen whether actual results going forward will mirror test results. In this sense fundamental indexing is linked to so-called fundamental analysis.
Most index investors will opt for products that track capitalization-weighted indices. But even among those, there can be several indices available within individual asset classes. Fortunately, over the past several years, the methodologies of prominent index providers have converged, alleviating somewhat the challenges previously faced by investors when evaluating similar indexes across providers.
Tracking error can have two meanings:
- the difference between the index total return and the total return of the fund -- this is also known as "tracking difference", or sometimes the "excess return" if the definition is reversed (total return of the fund minus total return of the index); or
- the "annualized standard deviation of daily return differences between the total return performance of the fund and the total return performance of its underlying index"  (see also Wikipedia: tracking error).
Both definitions are measures of how closely an index fund or ETF follows the index to which it is benchmarked. Tracking difference is calculated by substracting the fund's NAV return from the index return for the same period; typically both of these numbers can be found on the fund sponsor's website. The most obvious source of tracking difference is the MER. But factors such as currency hedging, cash drag, poor sampling, changes to the underlying index, index reconstitution, securities lending, and "fair value pricing" can play a role too.. A review of 2013 excess returns and tracking errors for several categories of index ETFs is available from National Bank Financial. Note that despite their attractive name, "excess returns" are almost always negative, i.e. the funds return less than their benchmarks.
It is possible for investors to purchase currency-hedged versions of some index funds and ETFs. But the dominant opinion on the Financial Wisdom Forum is not to hedge the currency exposure of foreign stocks because:
- over several decades, the currency fluctuations should even out
- hedging adds to costs
- for Canadians, hedging may add to the volatility of portfolios
In contrast, foreign bonds should always be hedged to avoid extra volatility.
- The case for indexing, Christopher B. Philips, Vanguard research, February 2011. Viewed January 21, 2015.
- CFA Institute, Chapter 2 Security Market Indices (Powerpoint presentation - undated), viewed January 21, 2015.
- Dow Jones, Dow Jones Select Dividend Indexes Methodology Overview, viewed Feb. 25, 2009.
- Determining the appropriate benchmark: A review of major market indexes, Vanguard research, April 2010. Viewed January 22, 2015.
- Canadian Couch Potato, How Well Does Your ETF Track Its Index?, viewed December 27, 2014
- ETF.com, Understanding Tracking Difference And Tracking Error, viewed January 24, 2015
- Chiefalo et al., Passive Equity Index ETF Performance Review: Full-Year 2013, National Bank Financial, January 19, 2014, viewed January 24, 2015
- Vanguard Canada, Understanding excess return and tracking error, January 15, 2015, viewed January 24, 2015
- Canadian Couch Potato, What Causes an ETF’s Tracking Error?, viewed December 27, 2014
- Canadian Couch Potato, When You Can Ignore Tracking Error, viewed January 24, 2015
- Stock Indices | TMXmoney for a list of the indices.
- Determining the appropriate benchmark: A review of major market indexes, Vanguard research, April 2010
- William F. Sharpe, Indexed Investing: A Prosaic Way to Beat the Average Investor. May 1, 2002.
Bogleheads forum discussions
- T. Larimore, What Experts Say About "Indexing"; a collection of quotes about indexing from Bernstein, Bogle, Buffet, Cramer (Cramer?), Ellis, Fama, Ferri, French, Lynch, Malkiel, Milevsky, Miller, Sharpe, Siegel, Sinquefield, Swedroe, Swensen, Zweig and others