As a hypothetical portfolio of holdings, indexes act as benchmark comparisons for a variety of purposes across the financial markets. These three indexes include the 30 largest stocks in the U. Since they include some of the most significant U. Other indexes have more specific characteristics that create a more narrowly targeted market focus. For example, indexes can represent micro-sectors or maturity in the case of fixed income.
Indexes can also be created to represent a geographic segment of the market such as those that track the emerging markets or stocks in the United Kingdom and Europe. The FTSE is an example of such an index. Investors may choose to build a portfolio with diversified exposure to several indexes or individual holdings from a variety of indexes. They may also use benchmark values and performance to follow investments by segment. Some investors will allocate their investment portfolios based on the returns or expected returns of certain segments.
Further, a specific index may act as a benchmark for a portfolio or a mutual fund. Each fund has a benchmark discussed in its prospectus and provided in its performance reporting, thus offering transparency to investors. Fund benchmarks can also be used to evaluate the compensation and performance of fund managers.
The average was composed of nine railway companies, a steamship company and Western Union. Institutional fund managers also use indexes as a basis for creating index funds.
Individual investors cannot invest in an index without buying each of the individual holdings, which is generally too expensive from a trading perspective. Therefore, index funds are offered as a low-cost way for investors to invest in a comprehensive index portfolio, gaining exposure to a specific market segment of their choosing.
Index funds use an index replication strategy that buys and holds all of the constituents in an index. Investors often choose to use index investing over individual stock holdings in a diversified portfolio. Investing in a portfolio of indexes can be a good way to optimize returns while balancing risk.
For example, investors seeking to build a balanced portfolio of U. Investors may also choose to use market index funds to invest in emerging growth sectors. Some popular emerging growth indexes and corresponding exchange traded funds ETFs include the following:.
Bloomberg Barclays Indices. Accessed Aug. FTSE Russell. Library of Congress. Reality Shares. First Trust. Portfolio Construction. Alex is a financial analyst at Morgan Stanley. Then, Alex is asked to break down the Dow Jones Industrial Average index, which a price-weighted index and allocates weights based on the stock prices.
Alex uses a sample of 20 stocks that are tracked by the Dow Jones Industrial Average index and performs an analysis based on the stock price. Kat Tretina is a freelance writer based in Orlando, FL.
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