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What is an index?

It’s too difficult to monitor each investment within every market – there are over 1,000 different companies listed on the main market of the London Stock Exchange alone. Luckily, investors can judge sentiment through the eye of an index.

An index is essentially a list of investments selected to represent a sector or region. By looking at the performance of an index, investors can assess the health of a market and use it to inform important investment decisions. Indices are also used as key benchmarks to compare investment performance.

Reflecting sentiment within a market and tracking performance, indices have improved transparency and have made the inner workings of the financial markets easier to digest.

You can easily gauge how investors feel about global events, identify when markets are in a bull or bear phase, and make crucial international comparisons – essential for when you want to build a globally diverse portfolio.

With many indices reaching both record highs and record lows over the last half a decade or so while outperforming some funds that had been carefully selected by fund managers, many people have wanted to invest in an index rather than just use it as a benchmark.

The history of the index

The first index was created by founder of The Wall Street Journal, Charles Dow, in 1896. Wanting to provide investors with information about stocks during a highly speculative post-recession market, the journalist decided to build the Dow Jones Industrial Average, which monitored the 12 largest companies in the US.

Dow kept the calculation simple, he added up the price of each constituent of the index and divided it by 12 to show the average. Today, the Dow Jones covers 30 stocks and is less concentrated on the industrial sector.

In general, indices are usually calculated by the member’s market value – the value of all the shares on the market. The larger the company’s market value, the bigger its percentage of the index – the higher its ranking.

Today, there are a number of indices covering the global markets, including the US S&P 500, French CAC 40, MSCI family and London’s Footsie series – FTSE 100, FTSE 250 and FTSE 350. You can also get indices that reflect the bond markets and other global investments.

Investing in an index

Whilst there are a number of prestigious indices like the S&P 500 and FTSE 100 that are monitored by an army of analysts around the globe, anyone can create an index – it really is just a catalogue of investment names.

Unfortunately, as it’s essentially just a list, you can’t actually invest in an index, and recreating it in your portfolio would take a lot of time and capital – not only are you going to need to cover the trading costs of buying each investment on the index, but you’re going to have to put enough money in to benefit from the diversification.

Exchange-Traded Funds (ETF) are popular with investors looking for low-cost diversification in their portfolio. ETFs are a type of passive investment that track an index or group of investments, often replicating an index.

An ETF will buy the underlying assets of the investment it wants to track. If it’s an index, it will buy all the shares in that index, usually replicating the proportion of their market capitalisation. This fund is then sold on the market with a set number of units.   

For example, if an ETF tracked the S&P 500, it would mirror the constituents of the US index and would adjust portfolio weightings when appropriate. ETFs don’t guarantee returns, what they aim to do is deliver the same return as the market.

A diversified portfolio across regions and asset classes can help smooth out returns during volatile markets. If some investments in your portfolio come under pressure, gains made elsewhere should level out the performance.

ETFs are simple investment vehicles. As they’re traded over an exchange, they act like a share on the stock market. ETFs have a bid and ask price – the point at which a buyer wants to buy and a seller wants to sell. Their price fluctuates throughout the day as they are bought and sold by investors. Importantly, you can trade an ETF in seconds.

The advantages of investing in an ETF

With the asset management industry feeling the heat from margin pressures, increased regulation and competition, ETFs have surged in popularity.

Assets invested in European-listed ETFs and products reached $802 billion in 2017, according to data provider ETFGI. Although this is still a small segment of the $4.8 trillion global market, it’s the fastest-growing, with 40% growth year-on-year.

So, why are ETFs so popular with investors?

  • Diversification – diversification allows you can manage the risk in your portfolio by spreading your money across different investments. ETFs recreate the investments in an index, for example, which are diversified by their very nature.
  • Low-cost – their passive nature makes them low-cost investments. The less you have to pay in charges, the more money you can keep invested to benefit from compound interest
  • Transparent – you can see what you’re invested in at any time, this isn’t always the same for actively managed funds
  • Liquidity – it’s important you know how easily and quickly you can turn your investments into cash, without this impacting the overall value of your investment.
  • Flexibilitytrading ETFs on an exchange means you can enhance your strategic asset allocation and make the most of shorter-term trends
  • Access all asset classes – you can invest in ETFs that cover all asset classes

How to invest in an ETF

Although investing in ETFs is as simple as buying and selling stocks and shares on a DIY investment platform, it can be difficult constructing your portfolio in a way that suits you and your financial goals.

The composition of the investments within your portfolio should reflect your risk level and the market conditions of the time.

Strategic asset allocation defines the long-term goals of the portfolio, whilst the tactical strategy makes the most of any alternative options along the way. ETFs can be used as the crucial building blocks of your portfolio to reach your long-term goals, whilst their flexibility and liquidity means they can make the most of shorter-term market trends.  

When you’re picking which ETFs to include in your portfolio, you need to look at the benchmark it’s tracking and monitor its efficiency. How much will it charge you in fees? What’s the tracking difference or volatility of its performance? You also need to make sure you’re getting the diversity you’re paying for.

The ETF universe is huge, and your options are growing by the day. It can feel intimidating when you’re trying to pick the best investments that will help you and your family.

Investing by yourself takes in-depth knowledge, skill, and quite a bit of money to do successfully. Many investors prefer to give their money to the experts to invest for them.

At Moneyfarm we provide our investors with cost-effective regulated investment advice to ensure we’re offering the best investment solution to our customers to help their money grow.

After getting to know more about you, your financial background, your appetite for risk and financial knowledge, we assign you an investor profile that acts a bit like your investor DNA. We then match you to a portfolio that reflects your investor profile, time horizon, and risk profile.

We build and manage your portfolios, rebalancing them to keep it in line with your requirements. We use ETFs to build out portfolios, to provide a low-cost, transparent, flexible and efficient investment solution to our customers.

Once you invest your money, you can focus on the important things in life. Our team of experts monitor the markets daily on your behalf, analysing any investment opportunities, and executing trades – you don’t need to do a thing.

Photo by FUTURE on Unsplash

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