Stock indexes
We are interested in pursuing diversification to the point of making our portfolio free, to the greatest possible extent, of avoidable risks such as one individual company or sector going down. One criteria for obtaining such diversification, in what regards to U.S. large-capitalization companies (these are, big companies or, as investors say, large-caps) is using the same proportion as recognized stock-market indexes such as the Dow Jones Industrial Average (DJIA) or the Standard and Poor's 500 (S&P500). These indexes were created for calculating measures that represent the whole of the stock market or, in this case, of the universe of large-cap companies. They are aggregate values resultant from the combination of many stock, each one in a proportion defined by their market value or by other similar criteria, depending on the index.
The original intent of stock-market indexes was to provide a means for quantifying ups and downs of the portion of the stock market they represent. For example, if the DJIA goes up a 0.8%, one may as well say that large-cap companies went up a 0.8%. Thus, when the index was defined, they cared to use an assignment that takes all that stock into account, in proper proportions. This work can be utilized for the composition of funds too. Actually, although the DJIA is the most-widely known index, it is not used for the composition of funds, because it includes only 30 companies. The S&P500, which lists 500, provides better diversification and has more acceptance among the experts.
There are other indexes for other universes of stock, some are more accepted than others. For example, there is the Russell 2000 for small-cap U.S. companies, Wilshire 5000 for the whole of the US market, the NASDAQ-100 for companies listed in the NASDAQ stock exchange (many are related to technology), the FTSE 100 (Footsie) for British large-caps, NIKKEI for Japanese and lots more.
Index funds
Funds that follow index are called, not surprisingly, index funds. Many mutual-funds and ETFs are index funds. Many times the term index fund is applied to all passively-managed funds (these are those funds where purchasing decisions are not decided by a manager but follow a predefined formula, such as the ones that define an index). If the passively-managed fund follows a previously-established index, the merging is clear. If it doesn't, it also makes some sense, because it can be argued that the formula created for deciding the funds' composition is actually the definition of a new, ad-hoc index.
The underlying assets of index funds are traded infrequently, only at index updates, which occur to adapt to the evolution of companies, as some grow more than others. This results in lower fees and greater tax efficiency, as we shall later explain. Thus, index funds are great instruments for the diversified buy&hold investor.
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