What is the Purpose of Indexes and Index Funds?

This post, Indexes Defined, is the first in a series of four designed to give you a clearer understanding of indexes and index funds and their uses.

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 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 of blog posts, we’re going to cover some of the ins and outs of indexes and the index funds that track them.

What Is an Index?

Let’s set the stage with some definitions.

An 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):

The Role of Indices in Research and AnalysisSo, what role do indices play behind the scenes, beyond the headlines and day-to-day ticker updates? Quite a big one, actually.

Indices serve as financial “yardsticks” that just about everyone in the investment world relies on for research and analysis. They provide a common reference point—sort of like the official scorekeeper in a game—that makes it possible to track market movements, sector performance, and broader economic trends.

Here’s how professionals put indices to work:

Evaluating Performance: Analysts use index data to compare how individual stocks, portfolios, or sectors measure up against the broader market. If a fund consistently beats the S&P 500 or TSX, for example, it’s cause for celebration (and maybe some bragging rights).
Spotting Trends: Whether it’s a Wall Street strategist or a government policy maker, many turn to indices to identify patterns in economic growth, sector momentum, or market sentiment.
Guiding Decisions: Portfolio managers and advisors often use index benchmarks to help decide what to buy, hold, or sell. Even institutions may use indices to shape policy—think of an index that tracks unemployment or healthcare costs, which might catch the eye of policy makers.
In short, indices provide the essential language and framework that help investors, analysts, and decision-makers make sense of a famously noisy marketplace.

What Are Factor Indices, and What Do They Target?

Now, not all indexes are built just to track a broad market or geographic region. Enter factor indices. Rather than representing the entire market, these indices are constructed to zero in on specific characteristics—also known as “factors”—that have historically driven returns over time.

Some commonly tracked factors include:

Value: Focusing on stocks believed to be undervalued relative to fundamentals.
Momentum: Targeting companies whose prices have been rising quickly.
Low Volatility: Selecting holdings with more stable price movements.
Quality: Seeking businesses with robust balance sheets and reliable earnings.
What makes factor indices unique is that they allow investors to pursue these characteristics directly, instead of just mirroring the market as a whole. Strategies based on factors were once mostly the domain of active managers, but today, they’re widely accessible to individual investors through index funds and ETFs that track these specific baskets.

Factor indices, in essence, help investors go beyond “owning the market,” letting them emphasize certain investment styles or risk exposures within their portfolios.

Sector Indices vs. Broad Market Indices

Now that we’ve name-dropped a few of the big players, let’s break things down a bit further. Not all indexes are cut from the same cloth—some cast a wide net over the entire market, while others take a laser-focused approach.

Sector Indices:
If markets were a buffet, sector indices would be the dish-specific stations. Instead of sampling everything, they zero in on particular slices of the market—think technology or healthcare, for example. There are even sector indices drilled down to cover more specialized areas, like biotech within healthcare or software within technology. This focus lets investors track and invest in specific industries they believe have strong prospects, without getting the unwanted side dishes from other sectors.

Sector indices don’t stop there—they can also be tailored to regions (say, European banks versus American banks), market capitalizations (small-cap versus large-cap), or even investment styles, such as value stocks or fast-growing companies known as “growth” stocks.

Broad Market Indices:
In contrast, broad market indices try to capture the big picture. They aim to represent entire markets or major asset classes—think of them as the all-you-can-eat salad bar, with a bit of everything included. The S&P 500, the FTSE 100, and the MSCI World Index are classic examples. These “baskets” typically include companies from multiple industries, providing a snapshot of how the overall market is faring.

So, in a nutshell: sector indices let you zoom in; broad market indices let you zoom out. Both serve as handy benchmarks—whether you want the full view of the market, or just a taste of your favorite segment.

How Fixed Income Indices Work

Shifting gears from stocks, let’s talk bonds. Just as equity indexes bundle together stocks to take the pulse of specific slices of the market, fixed income indices do much the same for bonds. These indices measure how groups of bonds—government, corporate, municipal, and beyond—are performing as a collective.

Here’s how it works: an index provider (think Bloomberg Barclays, FTSE Russell, or ICE) builds a list of bonds based on criteria such as region, issuer type, credit rating, or maturity range. The index then tracks the combined value and returns of those bonds over time. This gives investors a reliable reference point for tracking the ups and downs of the bond market—or even just one corner of it, like U.S. Treasuries or global corporate bonds.

Why Fixed Income Indices Matter
So what’s the point? For one, they shine a light on a market that often feels murky or intimidating, offering a transparent way to measure performance and risk. They also help investors diversify, as broad-based bond indices pull together many issuers, sectors, and maturities—helpful for managing risk.

In practice, these indices serve a few key purposes:

Benchmarking: Investors and fund managers use them to assess how their bond picks are performing—are you keeping up with, or trailing, the broad bond market?
Passive investing: Much like the S&P 500 for stocks, there are index funds and ETFs designed to simply mirror bond indices, giving investors easy, low-cost access to the asset class.
Market insight: Fixed income indices provide a snapshot of trends in yields, risk, and diversification benefits on a global scale.
And just like their stock market cousins, bond indices can evolve—new bonds are added and old ones drop off, keeping the index relevant to current market conditions.

What About Commodity Indices?

While most folks are familiar with indexes that track stocks or bonds, there’s another major player on the field: commodity indices. These are designed to measure the performance of baskets of physical goods—think oil, gold, wheat, or even coffee. Unlike equity or fixed income indices, which track shares of companies or bonds, commodity indices reflect price changes in raw materials themselves.

Commodity indices behave a bit differently, too. Their performance is often driven by shifts in global supply and demand. For instance, a bumper crop or a sudden oil shortage can send prices swinging—sometimes more dramatically than you’ll see in the stock or bond world. Because of this, commodity indices frequently serve as benchmarks for investors or asset managers who want to hedge against inflation or diversify beyond traditional stocks and bonds.

There’s also a variety of ways these indices are built. Some are equally weighted for maximum diversification across different commodities, while others might give heavier weight to more dominant or liquid markets. And some use more complex methods—like rolling contracts or adjusting for seasonality—to better reflect the quirks of the commodities markets.

In short, if equities measure company performance and bonds show lending trends, commodity indices give us insights into the price dynamics of the goods we use and consume every day.

What Are Strategy and Thematic Indices, and How Are They Used?

In addition to the classic benchmarks, the world of indices has expanded to include strategy and thematic indices—each with its own spin.

Strategy indices set out to track specific investment approaches rather than simply mirroring a broad market. For example, they might focus on companies with strong dividends, target low-volatility stocks, or use other screening rules and weighting methods to highlight particular investment “factors” like value, momentum, or quality. The idea is to replicate the returns you’d get from following a specific investment style, but in a rules-based, systematic way.

Thematic indices, on the other hand, zoom in on specialized corners of the market. Think of sectors or trends that are especially relevant at a certain time—like green energy, cybersecurity, artificial intelligence, or companies tied to infrastructure spending. These indices allow investors to target highly focused slices of the market they believe have long-term growth potential or align with their personal values.

Both strategy and thematic indices are often used by fund companies (think ETFs and mutual funds) as backbones for products that let investors easily tap into these strategies or themes—without having to research and buy dozens of individual stocks on their own.

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”?

How Do Financial Professionals Use Index Data?

Indexes aren’t just a handy measuring stick for average investors—they’re the daily toolkit for financial pros, too. Whether it’s Wall Street analysts, portfolio managers, or government policy folks, index data plays a starring role in their decision-making.

For starters, analysts often turn to index data to compare the performance of a specific company or sector against the broader market. If a particular stock is soaring or slumping, was it riding a wave of general market optimism, or was it marching to its own drummer? By comparing to a relevant index—say, the S&P 500 or the Nasdaq Composite—analysts can put those moves into context.

Portfolio managers use indexes as benchmarks to see how their fund’s returns stack up against the market. “Did we beat the FTSE 100, or lag behind?” is a regular refrain.
Quantitative analysts tap into real-time index movements to spot patterns or trading signals, whether they’re hunting for opportunities or managing risk.
Economists and policymakers might watch indexes related to employment or consumer prices to get a pulse on the broader economy—a jump in an index tracking manufacturing, for example, might prompt questions about interest rates or regulations.
In short, indexes give everyone a common reference point. They help cut through the noise and make it easier for the many voices in finance to speak the same language—no translation required.

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 an 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 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.

Why Can’t You Invest Directly in an Index?

This brings up a common point of confusion: while you might hear about people “investing in the S&P 500” or “tracking the Dow,” you can’t actually buy shares of an index itself. Why is that?

An index is essentially a mathematical construct—a list and a set of rules used to calculate the performance of a selection of securities meant to represent a particular corner of the market. It’s like tracking the average temperature in several cities to get a sense of global warming—you can’t “buy” the average, just as you can’t own an index outright.

Instead, what you can do is invest in financial products—such as index funds or exchange-traded funds (ETFs)—that are specifically designed to mimic the holdings and performance of these indexes as closely as possible. These index-based investments do the heavy lifting for you, purchasing the underlying stocks (or bonds, or other components) in the same proportions as the index. The result: your returns should closely track the index, minus those ever-present expenses and trading costs.

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.