Since nearly every media outlet on the planet reported the news, you probably already know that the Dow Jones Industrial Average topped 20,000 for the first time on January 25, 2017. But when a popular financial index like the Dow is on a tear, up or down, what does it really mean to you and your investments?
Great question. In this multi-part series, we’re going to cover some of the ins and outs of financial indexes and the index funds that track them.
What Is a Financial Index?
Let’s set the stage with some definitions.
A financial index tracks the returns generated by a basket of securities that an indexer has put together to represent (“proxy”) a particular swath of the market.
Some of the familiar names among today’s index providers include the S&P Dow Jones, MSCI, FTSE Russell and Wilshire. It’s perhaps interesting to note that some of the current index providers started out as separate entities – such as the S&P and the Dow, and FTSE and Russell – only to consolidate over time. In any case, here are some of the world’s most familiar indexes (with “familiar” defined by where you’re at):
- S&P 500, Nasdaq Composite, and Dow (U.S.)
- S&P/TSX Composite Index (Canada)
- FTSE 100 (U.K.)
- MSCI EAFE (Europe, Australasia and the Far East)
- Nikkei and TOPIX (Japan/Tokyo)
- CSI 300 (China)
- HSI (Hong Kong)
- KOSPI (Korea)
- ASX 200 (Australia)
…and so on
How Are Indexes Constructed and What Are the Main Weighting Methods?
Now that we know what a financial index is, how do they actually come together? It all comes down to construction—and, particularly, how the index’s individual holdings are weighted. The approach chosen can have a significant impact on both the performance of the index and what story it tells about the market slice it aims to represent.
Let’s look at some of the main methods used to weight index components:
Market Capitalization-Weighted: Here, larger companies—those with higher total market value—carry more influence. Indices like the S&P 500 use this approach, meaning a tech giant like Apple or Microsoft wields more weight than a smaller company in the lineup.
Price-Weighted: In this model, the absolute share price of each component determines its heft in the index. Higher-priced stocks get a bigger piece of the pie, regardless of the company’s overall size. The Dow Jones Industrial Average is a classic example.
Equal-Weighted: This egalitarian method gives every company in the index the same importance. Whether you’re a goliath or a minnow, each seat at the table is equally spaced. This can produce very different returns compared to market cap- or price-weighted alternatives.
There are other, less common approaches (such as weighting by fundamentals or dividends), but these three are by far the best-known. Each method paints a slightly different picture—sometimes dramatically so—of the markets they aim to mirror.
How Do Total Market Index Funds Differ from Other Index Funds?
A good place to start is by understanding the distinction between total market index funds and other, more narrowly focused index funds.
Total market index funds are designed to track virtually all publicly traded companies within a specific market, such as the entire U.S. equity market. Think of them as giant nets trying to capture every fish in the sea, regardless of size or species. If you own a total market index fund, you essentially own a tiny piece of nearly every company listed in that market—from household names to small up-and-comers.
On the other hand, other index funds typically zoom in on a slice of the market pie. For example, some might track only large-cap companies (like those in the S&P 500), focus on a particular industry, or even target foreign markets or specific types of bonds. These are more like casting a line for a specific kind of fish in a certain pond.
Here’s a quick comparison:
Total market index funds
Broadest possible diversification in a single fund
Designed to mirror an entire market’s performance
Captures large-, mid-, and small-cap stocks (and sometimes micro-caps too)
Other index funds
Track a specific segment (such as technology stocks, small-caps, or international companies)
Offer exposure to a subset rather than the whole market
May focus on particular factors, like value or growth
So, if your goal is to align your investments with the performance of an entire market, total market index funds deliver the most all-encompassing coverage. If you want to target something more specific or complement your portfolio with different investment strategies, specialized index funds offer a more focused approach.
What Are Some Commonly Used Bond Indexes?
Of course, it’s not just stocks that have a seat at the index table. There are plenty of indexes out there keeping tabs on the wide and varied world of bonds, too.
The bond market has its own lineup of heavy hitters, including:
Bloomberg U.S. Aggregate Bond Index: Often called the “Agg,” this broad benchmark tracks a basket of U.S. Investment-grade taxable bonds—including government, mortgage-backed, and corporate bonds.
FTSE World Government Bond Index (WGBI): Focuses on government bonds across developed markets worldwide, giving a global flavor to fixed income comparisons.
J.P. Morgan Emerging Market Bond Index (EMBI): Zeroes in on government bonds from emerging market countries—a go-to for those interested in a little international spice with their fixed income.
Much like their stock market cousins, these bond indexes give investors a yardstick for measuring performance, as well as insights into how the overall bond market (or a particular slice of it) is behaving.
Why Do We Have Indexes?
Early on, indexes were designed to offer a rough idea of how a market segment and its underlying economy were faring. They also helped investors compare their own investment performance to that market. So, for example, if you had invested in a handful of U.S. stocks, how did your particular picks perform compared to an index meant to track the average returns of U.S. stocks? Had you “beat the market”?
Then, in 1976, Vanguard founder John Bogle launched the first publicly available mutual fund specifically designed to simply copy-cat an index. The thought was, instead of spending time, money and energy trying to outperform a market’s average, why not just earn the returns that market has to offer (reduced by relatively modest fund expenses)? The now familiar Vanguard 500 Index Fund was born … along with index fund investing in general.
There are some practical challenges that prevent a financial index from perfectly replicating the market it’s meant to represent. We’ll discuss these in future segments. But for now, the point is that indexes have served investors across the decades for two primary purposes:
Benchmarking: A well-built financial index should provide an approximate benchmark against which to compare your own investment performance … if you ensure it’s a relatively fair, apples-to-apples comparison, and if you remain aware of some of the ways the comparison still may not be perfectly appropriate.
Investing: Index funds that replicate indexes allow you to indirectly invest in the same holdings that an index contains, with the intent of earning what the index earns, net of fees.
Common Misconceptions and Overlooked Differences Among Index Funds
Despite their popularity, not all index funds are created equal—or as straightforward as they may appear at first glance. Let’s unpack some of the easy-to-miss nuances and common misunderstandings around these investment vehicles:
Index Mutual Funds vs. Index ETFs:
While both options track market benchmarks, they’re not interchangeable. Mutual funds are typically traded at the day’s closing price, whereas ETFs (Exchange-Traded Funds) can be bought and sold throughout the day, just like individual stocks. This flexibility means ETFs can react faster to market movements, but it may also open the door to intraday volatility you wouldn’t otherwise notice in a mutual fund.
Not All Indexes (or Funds) Are Alike:
It’s tempting to think, “an S&P 500 index fund is an S&P 500 index fund”—but subtle differences exist. Providers may track the same index but employ different “sampling” methods or securities lending strategies. This can affect everything from tax efficiency to tracking error (how closely a fund matches the performance of its underlying index).
Expense Ratios Add Up:
Index funds are celebrated for their low costs, but “low” doesn’t always mean “lowest.” Differences in expense ratios, while seemingly minor on paper, can compound over time, taking a real bite out of your long-term returns.
Hidden Risks:
Just because an index fund is diversified doesn’t mean it’s risk-free. In some cases, funds may concentrate heavily in a single sector (think tech stocks in the Nasdaq), leaving investors more exposed than anticipated. It’s also important to know that neither fund structure nor indexing can fully insulate you from market downturns.
Liquidity and Trading Costs:
Less well-known indexes, especially in international or niche markets, might track securities that are thinly traded, which can affect liquidity and sometimes lead to wider bid-ask spreads or additional trading costs.
In short, while index funds can be powerful tools for investors, it pays to look under the hood and understand the similarities—and differences—among your options before you jump in.
Can Index Fund Investors Lose Everything?
It’s a question that comes up from time to time: If you invest in an index fund, could you lose your entire investment?
Short answer: It’s extremely unlikely—but not impossible in the most catastrophic scenarios.
Here’s why: Index funds are designed to mirror the performance of a broad market index, such as the S&P 500 or FTSE 100, by holding securities from many different companies. This built-in diversification significantly reduces the risk of a total loss, since for that to happen, every single underlying company in the index would have to become completely worthless. In practical terms, that would require a collapse of the entire economic system the index represents—something previously reserved for the realm of disaster movies and dystopian fiction.
Risks are still real, of course. An index fund’s value can decline sharply during a market downturn, and certain specialized or highly concentrated index funds can carry higher risks. That said, the classic, broad-based index funds tend to weather the ups and downs better than most—though no investment is ever entirely risk-free.
The bottom line: while you might see your index fund investment fluctuate (sometimes uncomfortably so), a total wipeout scenario is exceedingly rare for broad market index funds. Sensible diversification and an understanding of what you own remain your best allies.
What Makes for a “Good” Expense Ratio?
When considering an index fund, it’s crucial to pay attention to the expense ratio—the percentage of your assets that a fund manager charges annually to cover operating costs. In other words, this is the “price of admission” for investing in the fund, and as any frugal shopper (or savvy investor) knows, lower costs can make a big difference over time.
So, what’s considered a good expense ratio these days? For most passively managed index funds, particularly those tracking widely followed benchmarks like the S&P 500, expense ratios have become remarkably low, thanks to ongoing competition among providers like Vanguard, Fidelity, and Schwab. It’s now common to see expense ratios ranging from 0.02% to 0.10%—that’s just $2 to $10 annually for every $10,000 invested.
Here’s a quick guide:
0.02%–0.10%: Excellent for broad U.S. Market or S&P 500 index funds
0.10%–0.20%: Typical for international or specialized index funds
Above 0.20%: Worth a closer look—make sure you’re getting extra value for the higher fees
Keep in mind, the race to the bottom on fees is generally good news for investors, but an ultra-low fee isn’t the only thing that matters. It’s best to glance under the hood and ensure the index fund actually tracks the index efficiently, avoiding large “tracking errors.” But all else equal, lower expenses mean you keep more of your returns.
How Do Indexed Annuities and Adjustable-Rate Mortgages Use Financial Indexes?
So where else do these financial indexes show up in real life? Beyond investments like mutual funds and ETFs, you’ll also find them popping up in products like indexed annuities and adjustable-rate mortgages (ARMs).
Let’s take a closer look:
Indexed Annuities:
Think of an indexed annuity as an insurance contract with a twist—it ties your rate of return to a market index, such as the S&P 500 or Dow Jones Industrial Average. But there’s a catch: while you might benefit from gains if the index rises, your returns are typically limited by caps or participation rates. For example, if the S&P 500 goes up 12% one year and your annuity has a 7% cap, you’ll only collect 7% that year. If the index declines, some contracts promise you won’t lose value, but you also won’t benefit from the bigger market returns.
Adjustable-Rate Mortgages (ARMs):
Adjustable-rate mortgages work a bit differently, but still rely on indexes. The interest rate you pay adjusts periodically, based on a benchmark index plus a set margin. One of the popular benchmarks these days is the Secured Overnight Financing Rate (SOFR). Let’s say your ARM contract specifies an interest rate equal to SOFR plus 2%. If SOFR stands at 3%, you’ll pay an effective interest rate of 5%. When the benchmark moves, your mortgage rate follows suit—up or down.
In both cases, indexes help tie your financial product—be it an annuity or a mortgage—to broader market movements. This allows for the potential of both upside (and, in some cases, downside) in sync with how the underlying index is performing.
Indexes Are NOT Predictive
There is also at least one way indexes should NOT be used, even though they often are:
Index milestones (such as “Dow 20,000”) do NOT foretell whether it’s a good or bad time to buy, hold or sell your own investments.
Indexes don’t tell us whether the markets they are tracking or the components they are using to do so are over- or underpriced, or otherwise ripe for buying or selling. Attempting to use current index values as a way to time your entry into or exit from a market does not, and should not replace understanding how to best reflect your unique investment goals and risk tolerances in an evidence-based investment strategy.
In fact, market-timing of any sort is expected to detract from your ability to build wealth as a long-term investor, which calls for two key disciplines:
- Building a cost-effective, globally diversified portfolio that exposes you to the expected returns you’d like to receive while minimizing the risks involved
- Sticking with that portfolio over the long run, regardless of arbitrary milestones that an index or other market measures may achieve along the way
As one commentator observed the day after the Dow first broke 20,000: “Sensationalism of events like these [Dow 20,000] has the ability to trigger our animal spirits or our worst fears if we don’t have a long-term investment plan to keep them in check.”
So first and foremost, have you got those personalized plans in place? Have you constructed a sensible investment portfolio you can adhere to over time to reflect your plans? If not, you may want to make that a top priority. Next, we’ll explore some of the mechanics that go into indexing, to help put them into the context of your greater investment management.