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Investing 101: What is an Index and How Can It Save Me Money?

Investing 101: What is an Index and How Can It Save Me Money?

Popular indexes (or indices) like the DJIA, S&P500, TSX, or FTSE measure the market capitalization of publicly traded companies. Indexes track a specific segment of the market, based on various factors and weighting. For example, the DJIA follows only 30 large-cap blue-chip US companies, spanning various industries (excluding utilities and transportation). The DJIA however, is the most well-known of the indexes designed by the Dow Jones Indexes (DJI). Others include the DJI and SAM Group index that track companies focused on sustainability issues; Dow Jones-AIG Commodity Index that track future contracts for physical commodities. Specialty indexes include the Olympic-inspired Dow Jones Summer/Winter Games; the race-car centric Dow Jones Formula 1 Index; and the closely followed Dow Jones Luxury Index.

Morgan Stanley (among many other companies) also constructs their own indexes. The MSCI EAFE (Europe, Australasia and the Far East) for example, tracks a selection of stocks from 21 developed countries outside the US and Canada, with each country and market cap weighted differently. In general, the hundreds of thousands of indexes we can possibly track differ not only by sector, but by geographical location or even event.

As an individual investor, the importance of closely following indexes such as the DJIA and S&P500 are that they act as benchmarks that measure the performance of mutual funds and other investment vehicles. ETFs for instance, attempt to replicate the movement of the specific index that they follow. Mutual funds, on the other hand, try to provide returns superior to the market. In this case, an index is used as a barometer to measure performance of the fund and market.

But it is important to understand that an index provides a specific snapshot of how the market is generally performing. Hence, while indexes like the S&P500 are great at capturing where the economy as a whole is, they only measure the top 500 large-cap companies (with varying weight placed on each company). Though highly correlated, popular indexes like the DJIA and S&P500, which follow large-cap companies, don’t immediately capture how small-to-mid cap companies are performing at a specific moment in time, indexes for small-to-mid cap companies are readily available.