What is an index?

When you hear that “the market is up,” people are often actually referring to an index. An index is a collection of securities or other assets that are meant to represent the performance of an economic sector or portion of the market in reference to a point in time. Indices can be broad or narrow in focus. Some examples of indices and what they represent include:

• S&P/TSX Composite Index – The Canadian equitiesEquities Another word for investments in the stock market.+ read full definition market. This index contains stocks of the largest companies on the Toronto Stock ExchangeStock exchange A market in which securities are bought and sold.+ read full definition.
• FTSE TMX Canada Universe BondBond A kind of loan you make to the government or a company. They use the…+ read full definition Index – The Canadian investmentInvestment An item of value you buy to get income or to grow in value.+ read full definition grade fixed incomeFixed income An investment that pays regular income to you. Examples: Guaranteed Investment Certificates, Canada Savings Bonds…+ read full definition market.
• S&P/TSX Capped Energy Index – High-yielding stocks in the Canadian energy sector.
• S&P 500 – the U.S. equities market. This index contains stocks of 500 large companies with common shares listed on the New York Stock ExchangeNew York Stock Exchange An American stock exchange, and the world’s largest stock exchange by market capitalization. The exchange…+ read full definition or the NASDAQNasdaq the National Association of Securities Dealers Automated Quotation System. NASDAQ is a computerized system that…+ read full definition Stock MarketStock market The collection of markets and exchanges where stocks, bonds and other securities are issued or…+ read full definition.

These indices give investors a general idea of whether trades within these sectors or markets are experiencing an upward or downward momentum. Many index providers publish a description of how their indices are put together on their websites, so investors can better determine if an index’s focus matches their investment goals.

While people cannot usually investInvest To use money for the purpose of making more money by making an investment. Often…+ read full definition directly in the indices themselves, they can invest in index funds. Index funds, which are sometimes referred to as index trackers, aim to follow or mimic the performance of a specific index; the value of an index fundIndex fund A fund that invests in investments that track a specified target index or benchmark. For…+ read full definition will typically go up or down as the index goes up or down. Index funds are generally sold in the form of mutual funds or exchange-traded funds (ETFs).

Tracking the performance of an index is an example of a passive investment strategy. Funds that use passive investment strategies generally have lower costs than funds that use active investment strategies, because the passive fund’s portfolio managerPortfolio manager An investment professional who manages your investment portfolio. For example, they buy, sell and monitor…+ read full definition doesn’t have to do as much research or make as many investment decisions. While there can be advantages to active strategies, sometimes passive strategies can outperform active strategies, especially when the costs of the funds are taken into consideration.

However, one potential downside of index funds is that they may have less ability to respond to declines in the value of their investments than a more actively managed fund, because the index fund simply replicates the returns of an index, even if that return is negative.

What is active versus passive portfolio management

Active strategies usually involve the portfolioPortfolio All the different investments that an individual or organization holds. May include stocks, bonds and…+ read full definition manager buying and selling investments to meet a specific return target, or to outperform the return of the overall market or another identified benchmarkBenchmark A yardstick that you can use to measure the performance of an investment. Example: a…+ read full definition.

Passive strategies generally involve buying a portfolio of securities in order to track the performance of a benchmark or investment model. The holdingsHoldings Shares or other interests in a business. Also refers to investments in a portfolio.+ read full definition of a fund that uses a passive strategy are only adjusted if there is a change in the benchmark or investment model.

How do index funds work?

An “index fund” may sound simple enough to understand, but there are some key points investors should be aware of before purchasing an index fund. Most importantly – investors need to know what they’re investing in.

In addition to understanding the index itself, when considering which index fund to purchase, investors should also examine how an index fund replicates the returns of its index. While tracking the returns of an index is a passive strategy, an index fund’s portfolio manager has discretion in deciding how the fund will track the index.

Some funds replicate an index by actually investing in each security that makes up the index, while others try to replicate the index by only buying a sample of securities that possess the same characteristics and features as securities within the index. A third way that funds replicate an index is by using derivatives, such as forward agreements or swaps, which are financial instruments whose price is based on an underlying assetAsset Something of value that a company or an individual owns or controls. Examples: buildings, equipment,…+ read full definition. Each way has its advantages, drawbacks and risks, which should be understood by an investor before purchasing an index fund.

Additionally, some index funds track their index with a multiplier effect, by providing returns equal to two times the returns of the underlying index. Others track their index inversely, so when the index goes up, the index fund’s value goes down, and vice versa. These types of funds tend to make extensive use of derivatives and their returns can be quite volatile. The prospectuses of these types of index funds generally disclose that the funds may not be appropriate for long-term investing.

For all these reasons, it’s important for investors to understand what a fund is tracking, and how it does it. Some index funds are less simple, less diverse and less passive than investors might expect at first glance. This can all factor into whether the fund is appropriate for the investor given his or her investment objectives and constraints.

Investors should always understand what they’re investing in before making a decision.