What Is a Diversification Index?

One style of investing involves the allocation of assets into index funds. These are portfolios that may be managed by professionals but that do not change frequently. The purpose of such a fund is to perform like another market benchmark. A diversification index is one in which there may be exposure across different types of financial securities. Consequently, if one asset class or investment category falters, there is a greater chance that another might continue to generate profits.

In the financial markets, there are broad benchmark funds that reflect the overall performance in stocks. For example, in the U.S., the Standard and Poor's (S&P) 500 Index contains some of the largest equity securities that trade. In the UK, the Financial Times Stock Exchange (FTSE) 100 Index consists of the biggest stocks that trade on the London Stock Exchange. These indices are not limited to a certain sector. Instead, companies that are included in both funds meet size standards, based on a measure known as market capitalization, as well as regional requirements.

Major stock exchanges and investment firms create such indexes to illustrate performance in the broad financial markets. Investment managers who oversee portfolios that mimic trading in wider markets are providing clients with a chance to buy into a diversification index. Fund managers attempt to replicate the returns in the regional funds by forming their own portfolios that are comprised similarly to the market barometer. Investors can generally expect performance that is inline with the benchmark.

One of the primary benefits of index investing is cost. Money managers are generally able to keep the expenses for these funds relatively low, as there are only infrequent trades occurring. The financial advantage is typically passed along to diversification index investors, who gain the expertise of professional money management without paying excessive fees.

Diversifying is another generally positive approach to investing. When an individual is saving for a major event, such as retirement, they become vulnerable to the unpredictable fluctuations that often occur in the financial markets. By spreading money across different types of securities, the risk becomes shared with multiple categories. A diversification index can help someone to achieve appropriate risk.

Another potential reward for using a diversification index is the potential exposure to more than one asset class. For instance, in a balanced fund, an investor can become exposed to both stocks and bonds. If the equity markets are under-performing over a period of time, a portfolio could still meet expectations based on the income that bonds are generating.