What is a Financial Index?

Definition:

A financial index is like a measuring tape for an asset class or a segment of that asset class — By tracking a wide range of asset classes, indices give investors an idea how different markets perform.

🤔 Understanding a financial index

The financial markets use indices (the plural of index) to track market performance. Indices are used to monitor both the stock, bond asset classes. In the US markets, the S&P 500® is one of the most widely referenced indices. As such, the performance of the S&P is typically the benchmark used by professional investors to compare their total or part of their performance. Because actively-managed funds (like mutual funds) generally charge higher fees than index funds, investors expect returns that outpace their associated market indices.

Outperforming market indices over decades is no small feat. Most professional money managers fail to outperform the S&P 500 (Source: CNBC.com, March 15, 2019).

Example

Let’s say there’s a fictitious mutual fund called the ABC Fund. The ABC Fund invests in US-based stocks and generates a 15% return during the year. In this universe, the Index 9000 is the main equity index. During the year, the Index 9000 goes up in value by 20%. While ABC Fund went up in value, it underperformed its major market index. Despite making money, investors may still complain, because the investment product didn’t perform as well as its benchmark.

Takeaway

Indices are like the stock market’s thermometer...

They offer a temperature check that helps investors know if we’re in a bull or bear market. When an index climbs to new highs, it signifies a bull market, while when an index falls in value and hits new short-term lows, it signifies a bear market. Indices can also help investors assess the relative performance of professional financial advisors and money managers.

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What is an index?

When it comes to Wall Street, an index is a measure of performance (price changes) in a specific financial market. Indices exist for all aspects of the financial markets. For US stocks, the major indices are the S&P 500 and the Dow Jones Industrial Average (DJIA)®. As for the US bond market, the major index is the Barclays Capital US Aggregate Bond Index®. Outside the US, major stock and bond indices are covering Europe, Asia, and Latin America.

What are the major indices?

The most common index used as a proxy for the overall stock market is the S&P 500. The market value of all outstanding shares of S&P 500 stocks equals more than 75% of the total value of all US stocks. Another major stock market index is the Dow Jones Industrial Average (DJIA). The DJIA holds fewer stocks (just 30 companies), but it covers a wide swath of US-based blue chip stocks. Blue chip stocks are large, well-established companies. They are regarded for their financial stability and consistent profitability. Blue-chips typically don’t grow as fast as emerging technology stocks. But they generally are associated with steady growing dividends.

Other major indices for US stocks include the Nasdaq 100® and the Russell 2000®. The NASDAQ 100 tracks the 100 largest non-financial stocks listed on the NASDAQ exchange. The Russell 2000 is like the S&P 500, but for stocks with market values below $10 billion.

Looking at global investing, the MSCI EAFE® (Europe, Australasia, Far East) index is one of the main indices for international stocks. But there are scores of other indices tracking stocks across the globe. These include the S&P Global 100®, the S&P Global 1200®, The Global Dow®, and the FTSE All-World Index Series®.

For bonds, the Bloomberg Barclays Aggregate Bond Index is a major index. Other bond indices include Merrill Lynch Global Bond Index®, The Capital Markets Bond Index®, and the Citi US Broad Investment-Grade Bond Index® (USBIG). If you have a balanced portfolio of equity and fixed-income investments, paying attention to bond indices can be helpful in analyzing your portfolio’s performance.

How do you read an index?

The current value of an index is rarely the main data point. Instead, it is the change in value over a period of time (daily, weekly, monthly, quarterly, annual) that is usually most helpful to investors.

As an example, let’s use the fictional Index 9000 mentioned above. Let’s say in the past three years, the Index 9000 has gone up an average of 12% a year. The Index 9000’s average return over a 50-year period was 9%. This means the market is performing better than its history would suggest. This could indicate to investors that we are in a bull market for equities.

But how does index performance affect your life?

In the short-term, index performance is not an essential factor for your portfolio. But as a long-term investor, index performance matters. If you invest in mutual funds or other actively-managed portfolios, it is essential to see how well your investments are doing compared to their benchmark index.

You may be invested in funds/stocks that outperform the S&P 500 and other indices. Or you could have a portfolio that lags behind market performance. This could mean index funds (discussed more below) could be a better investment vehicle for your nest egg.

What is the relationship between trading indices, mutual funds, and exchange-traded funds?

Stock indices play an important role in the investment management ecosystem. Most mutual funds are actively managed. But a lot of mutual fund managers try to build portfolios that mirror returns of the major indices. While active mutual funds typically pick individual stocks over a broad index, many mutual funds are accused of being “closet indexers.” This means they build a portfolio of similar components to an index such as the S&P 500. This is to ensure the fund’s returns do not fall too far below the index benchmark.

On the other hand, Exchange Traded Funds (ETFs) typically have no qualms copying an index verbatim. The major ETFs are mirror portfolios of indices such as the S&P 500 and the DJIA. This gives investors the ability to “buy the index,” and see returns on par with the index’s performance.

You can view it like this: Index performance influences both active and passive investments. Active managers use indices to track their performance. To avoid rocking the boat, they sometimes become “closet indexers.” For passive investors (index funds, ETFs), index returns are basically their returns. They do not worry about fundamental analysis or picking the right stocks – They’re satisfied with the stock market’s historical long-term performance. They set it, and forget it.

What is an indexed annuity?

Indexed annuities are annuities tied to market returns. First things first, what’s an annuity?

The term “annuity” can be used to define any sort of situation where you receive periodic payments. (A pension is a prime example.) But in the insurance world, annuities are products people buy as a form of longevity insurance. Since annuities guarantee a fixed monthly payout for life, they can help people avoid outliving their savings.

With some annuities, you pay a lump-sum premium, and at a certain point, receive monthly payments. You can also make payments over time in order to finance the annuity. But your standard life annuity is typically fixed. That means the monthly payments you receive do not vary. So for investors looking for predictable returns, indexed annuities are an option.

Indexed annuities provide an index-tied rate of return for investors. When the indices tied to your annuity rises in value, you receive a higher annuity payout. But conversely, if the market sees declines in value, your payment will not decrease.

However, there is usually a cap that limits annual returns during a bull market. For example, let’s say you own an indexed annuity tied to the S&P 500’s performance. However, the indexed annuity has a 12% cap. This means even if the S&P 500 outperforms this cap, you won’t see the full benefit. Annuities typically have higher fees than other types of investment vehicles. While they may offer higher rates of return than more conservative fixed-income investments, fee transparency is nonexistent.

Along with fees, annuities charge a sales commission at purchase. These added expenses should be taken into account. There is plenty of marketing material out there touting the benefits of annuities. But do your own research before choosing indexed annuities over other types of investment vehicles.

What is a mortgage index?

Mortgage indices are used to price adjustable-rate mortgages. Your typical 30-year fixed mortgage would not use an index to set rates as this is determined by other factors. But adjustable-rate mortgages, or ARMs, use them to set the rate of interest on the mortgage.

With ARMs, the interest rate fluctuates based on the rate moves of the mortgage index. The most commonly-used mortgage index is the London Interbank Offer Rate or LIBOR. Typically, an ARM’s rate is LIBOR plus a certain added percentage. For example, let’s say you have an ARM that is LIBOR +2%. If LIBOR is at 2.5%, that means your mortgage rate is 4.5%.

What are index funds?

Indices themselves are not an investment vehicle. Because of this, the financial services industry offers index funds. Index funds are a type of mutual fund. Except, instead of the pool of capital being actively managed (being a manager selects specific stocks based on fundamental or other non-index criteria), index funds passively buy, sell, and hold securities that make up an index.

The largest/best-known index fund is the Vanguard S&P 500 Exchange-Traded Fund (ETF). Created by the industry’s founding firm (Vanguard), the Vanguard 500 replicates the S&P 500 in terms of what makes up the fund. Therefore, the ETF’s performance typically moves in lockstep with the S&P 500.

In the past decade, “passive investing” has become more popular. Since the Great Recession, retail investors have shunned actively-managed mutual funds.

Another benefit of index funds is their costs. The costs of an investment vehicle are typically expressed using the “expense ratio.” The expense ratio is the annual management fee relative to your investment value. For example, let’s say you purchase a mutual fund with an expense ratio of 1.5%. This means for every $10,000 you invest, the fund manager receives $150 per/year in compensation.

While active mutual funds tend to have average management fees of 0.73% (Source: Morningstar Fund Fee Study, May 11, 2018), index funds often have management fees as little as a few basis points (a basis point is 1% of 1%). Investing in low-cost investment vehicles tends to help improve long-term compounding of capital.

Index funds are not a foolproof investment vehicle. Index fund performance varies based on general market performance. Nevertheless, for small investors who wish to “set it and forget it,” index funds can be among the best investment vehicles out there.

What to look for in an index fund?

There are many index funds out there. Some track the S&P 500. Other track indices such as the DJIA and the NASDAQ 100. No matter which major index you want to track, there’s likely an ETF or index fund that allows you to do so.

But what should you consider before selecting an index fund? The first thing is the expense ratio. The expense ratios on index funds are generally much lower than on actively managed mutual funds. Mutual funds have expense ratios of around 1%. But you can find index ETFs with expense ratios of just a few basis points (1/100 of a percent).

The lowest-cost index mutual? funds charge a management fee of 0.02-0.04%. That means for every $10,000 you invest, you only pay $2 to $4 in fees.

Why are low fees such a big deal? Fees can be a significant hindrance long-term investment returns. Over a long-timeframe, your savings could compound into a tidy nest egg. But fees could eat up a noticeable portion of the potential end balance.

Another factor to look for is liquidity. Most major index funds are liquid. This means it is easy to buy and sell them on the exchange. Other ETFs may trade less frequently. This makes it difficult to enter or exit a position at the exact price you want.

Passive investors should still remain active in managing their portfolio. Review your finances at least annually to ensure your portfolio is in line with your risk tolerance and objectives.

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