Indexing
Also written Index tracking · Index replication · Indexed portfolio
Building a portfolio that mirrors an index constituent by constituent — the most common form of passive management, carried out either by full replication or by sampling.
In plain language
A portfolio manager has two broad choices. She can pick stocks herself and try to beat a benchmark. Or she can simply copy the benchmark.
Copying it is called indexing. The manager buys the index constituents and holds them in the index weights. She takes no view on any single stock.
Her one real decision is which index to track. After that, the index provider decides what the portfolio owns. When the index changes, the portfolio changes with it.
The pay-off is cost. There is no research team to fund, and very little trading. The workbook calls indexing the most common form of passive investing.
The trade-off is plain. An indexed portfolio can never beat the index. It is built to match it.
How it works
The definition (section 18.1.2). When the portfolio manager creates a portfolio which mirrors an index, the process is called indexing.
Indexing against the other passive strategy. Section 18.1.3 sets it beside buy and hold:
| Buy and hold | Indexing | |
|---|---|---|
| Who picks the stocks and weights | The manager | The benchmark index |
| Analysis needed | Each stock analysed by the manager | Manager only has to select the right benchmark |
| Trading | Negligible | Stocks added, removed or traded whenever the index is rebalanced |
| Main risks | Liquidity, information asymmetry, company closure, delisting | Index is liquid, transparent, widely traded and periodically rebalanced |
The two construction techniques (section 18.1.4). Full replication holds every constituent at index weight. Sampling holds a subset and substitutes similar stocks for the rest.
Choosing the index (section 18.4.2). A good index for an indexed portfolio should represent the desired market segment, have a documented methodology followed without exception, be transparent, be made up of widely traded liquid stocks with a high free float, and be reviewed and rebalanced periodically.
The scale the workbook records (section 18.4.1). In India, as of March 2020, 86 passive products held collective AUM of $24bn — against a mere $1bn across 26 products a decade earlier. In the US, passive AUM had touched $5 trillion across more than 7,000 index-based products on the same date.
A worked example
Illustrative figures. Anand runs a Rs 10 crore indexed portfolio against a four-stock benchmark. He replicates it fully.
| Constituent | Index weight | Holding |
|---|---|---|
| Stock A | 40% | Rs 4,00,00,000 |
| Stock B | 30% | Rs 3,00,00,000 |
| Stock C | 20% | Rs 2,00,00,000 |
| Stock D | 10% | Rs 1,00,00,000 |
He forms no opinion on any of the four. If Stock D halves, he does not sell it; he holds whatever weight the index gives it.
At the next review the index provider drops Stock D and adds Stock E at a 10% weight. Anand must sell his entire Rs 1,00,00,000 of D and buy Rs 1,00,00,000 of E on the effective date. He cannot wait for a better price — waiting is a bet against the index, which is the one thing an indexed portfolio is not allowed to do.
A new client brings in Rs 50,00,000. It is deployed in exactly the same proportions: Rs 20,00,000 into A, Rs 15,00,000 into B, Rs 10,00,000 into C and Rs 5,00,000 into E. No stock selection takes place at any point.
Why NISM asks about it
Chapter 18 (Equity Portfolio Management Strategies) opens with passive strategies: section 18.1.2 defines indexing, 18.1.3 compares it with buy and hold, and 18.1.4 gives the two construction techniques. Section 18.4 then contrasts active and passive management, and 18.4.2 lists the conditions a tracked index must satisfy.
Chapter 13 (Concept of Informational Efficiency), section 13.5.4, reaches indexing from the other direction — the rise of index funds as a consequence of market efficiency — and its sample question 4 asks what efficient markets and a lack of superior analysts led to (index funds).
Expect a question naming indexing as the most common form of passive management, one on the buy-and-hold versus indexing differences, and one on which conditions make an index suitable to track.
Common exam traps
- Indexing and buy and hold are both passive, but only indexing mirrors a benchmark. In buy and hold the manager still selects the stocks and their weights; the workbook classifies it as passive only because it trades so little.
- Indexing is the process; an index fund is a product. A PMS portfolio can be indexed without being a mutual fund scheme at all.
- Indexing trades more than buy and hold. Every index rebalance forces purchases and sales, which is precisely where tracking error comes from.
- The manager's discretion is not zero — it is spent once, on the choice of index. Section 18.4.2 exists because that single choice determines everything the portfolio will hold.
- Smart beta is not indexing. It is rule-based like indexing, but the rules and weights are designed by the manager, which the workbook describes as akin to active management.
Check yourself
1.According to the workbook, which is the most common form of passive equity portfolio management?
- a)Buy and Hold
- b)Indexing
- c)Sector rotation
- d)Market timing
Show the answer
Answer: (b) Indexing
The workbook states that indexing is the most common form of passive management, and that ETFs have played a big role in its growth.
Buy and Hold is also classed as passive, but it is not described as the most common. Sector rotation and market timing are active strategies.
2.Why is the Buy and Hold strategy classified as a passive strategy?
- a)Because it mirrors a benchmark index exactly
- b)Because the investment is not frequently traded to gain tactical advantages
- c)Because it uses only ETFs
- d)Because it involves no analysis of companies
Show the answer
Answer: (b) Because the investment is not frequently traded to gain tactical advantages
The workbook is explicit: Buy and Hold is not mimicking a benchmark, but it is often classified as passive because the investment is not frequently traded for tactical advantage.
Option A is the trap — that describes indexing. Option D is wrong because the manager analyses the company from every aspect before buying. Option C is invented.
3.According to Section 19.2 of the workbook, the three passive management strategies for bond funds are:
- a)Buy and hold, indexing and immunization
- b)Barbell, bullet and floaters
- c)Directional call, roll down and maturity extension
- d)Credit analysis, yield spread analysis and convexity
Show the answer
Answer: (a) Buy and hold, indexing and immunization
Section 19.2 names buy and hold, indexing and immunization as the three passive strategies.
Options B and C are active interest-rate driven strategies. Option D lists active analysis techniques.
Note that Section 19.2.3 later says immunization "is not a passive strategy like Buy and Hold", because it needs re-adjustment — but the list of three comes from 19.2.
Where this is taught
Free preparation for NISM Series XXI-BRelated terms
- Passive investingAn approach that buys a broad basket of securities, typically by tracking an index, to earn the return of the asset class as a whole rather than trying to beat it.
- Index fundsA passive open ended scheme that replicates or tracks a specific index, investing at least 95 percent of total assets in that index's securities, bought and redeemed from the fund rather than on an exchange.
- Tracking errorThe gap between the return of a passive fund and the return of the index it is trying to replicate — the measure of how faithfully an index fund or ETF does its one job.
- IndexA statistical indicator that tracks a portfolio of securities representing a market or part of it, expressed as a change from a base value — so the percentage move matters, not the number itself.
- Smart betaIndex-based investing that deviates from traditional market-cap weighting to emphasise factor exposure such as value, momentum, quality or low volatility. Sits between active and passive.
- Buy and Hold strategyA passive strategy of buying securities, or setting an asset mix, and then holding without trading — in equities for the long run, in bonds to maturity, and in rebalancing as "do nothing".
- Full replicationAn indexing technique that holds every security in the benchmark at the same, or nearly the same, weights as the index itself — practical for indices with few, liquid constituents like the Nifty 50 or Sensex.
- Index inclusion effectThe portfolio and price impact when an index rebalance adds or drops a constituent: full-replication funds must buy the entrant and exit the leaver in full, on the same date, whatever the price.
- SamplingAn indexing technique that tracks an index without holding all of it: some constituents are replaced by similar stocks, so the portfolio matches the index's risk and return rather than its exact list.
- Internal contradiction of efficiencyThe paradox that a market can only become informationally efficient if enough participants believe it is not — because it is their search for mispricing that drives prices to fair value.