Investing in indices: What you should know?

Financial indices have a lot going for them as an asset class. They are attractive to traders, mostly as long-term investments, as they offer inbuilt portfolio diversification – they are a cluster of top-performing stocks in a given country or sector – and because the underlying assets are not bought outright the handling fees are relatively inexpensive.

But what exactly is a financial index? It is a number of stocks grouped together to create one aggregate value that is used to benchmark, and measure price, against a market or sector’s performance. As such, their values correlate with the respective prices and constantly fluctuate; they rise if the markets go up, and decrease if they go down.

Stock market indices are used by investors as financial tools to follow market trends. They can be categorised in a number of ways. Some are multi-regional (like the MSCI World or the S&P Global 100) and defined geographically (such as continents), or even classed by income or industrialisation (for instance, Developed Markets, and Frontier Markets).

Next there are nation indices – which are more popular – that track a specific country’s stock-market performance. These tend to give a good indication of the state of a nation’s economy, because they group stocks of large organisations within that region. Examples include the American Standard & Poor 500, Japan’s Nikkei 225, and the United Kingdom’s FTSE 100.

Why Invest in Indices?

Indices allow investors to trade global equity market fluctuations without directly owning any stocks.

Indices can also be useful instruments to hedge – investors might wish to short sell indices as well as concurrently investing long in other stocks from the same market; or, indeed, go long when facing the opposite scenario. However, it should be noted that given stocks are designed to increase in value in the markets, by extension so too are indices.

Legendary investor Warren Buffett is known to adore indices. In 2007 he made a $1 million wager against Protégé Partners that hedge funds wouldn't outperform the Vanguard 500 Index Fund Admiral Shares. Buffett won, with his index fund returning 7.1 per cent while his competitor’s fund accrued an average of 2.2 per cent. There are no guarantees in the stock market, however Buffett insists that index funds, and a form of passive investing, are a smart long-term bet. As turnover rates are low so too are fees and taxes. "The trick is not to pick the right company," Buffett has said. "The trick is to essentially buy all the big companies through the S&P 500 and to do it consistently."