Indexes and index-tracking strategies are an increasingly important feature of the contemporary investment environment.
Index tracking has become a risk-averse strategy for institutional investors, and its popularity has grown strongly, especially within developed capital markets where it is considered difficult to outperform the market reliably.
Indexes (and indexed portfolios) are actively managed instruments which are constructed according to objective criteria. Their performance typically depends on the market capitalization (size) of stocks.
Index membership literally confers “investment grade” on firms because numerous managed funds are benchmarked to, or directly invested in, these stocks. Index membership also increases institutional investor ownership levels, trading liquidity, and research coverage by market analysts.
Index changes can have dramatic effects on stock prices and trading volumes, especially over the short to medium term; longer-term effects remain unclear.
Stock indexing, where investment portfolios mimic or replicate market indexes, has profound implications for both firms and investors. The practice stems from theoretical research which suggests that markets are informationally efficient. Since security prices generally reflect all public information, there is no point in employing active fund management and paying for investment research if there is no prospect of reliably beating the market. Whether or not you believe that beating the market is achievable—and this remains a perennial debate within academic and practitioner circles—the reality is that institutional investors make portfolio allocations with close reference to market indexes. The essential issue for investors and financial managers, therefore, is to be aware of how indexes are managed and to understand the implications for stocks arising from index tracking.
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