A stock market index is a tool used to measure the performance of a specific section of the stock market. It essentially tracks a basket of stocks and provides a single figure that reflects how those stocks are performing overall. This allows investors to compare the performance of a particular market segment or industry against the broader market or other indices, as well as gauge the overall health of the market by comparing current stock prices with historical prices.
Categories
Indices can be categorised in a number of ways, depending on the types of stocks they include:
Coverage Area
Global: These indices aim to represent the entire global stock market. For example, the MSCI All Country World Index (ACWI) tracks large and mid-cap stocks across 23 developed and 24 emerging markets.
Regional: These indices focus on a specific geographic region, such as the FTSE Developed Europe Index or the FTSE Developed Asia Pacific Index.
Country: These indices track a single country’s stock market, offering a glimpse into investor confidence in that nation’s economy. Examples include the S&P 500 in the United States, the Nikkei 225 in Japan, Germany’s DAX, India’s NIFTY 50, and the UK’s FTSE 100.
Stock Exchange: These indices track stocks listed on a particular stock exchange, such as the NASDAQ-100, or groups of exchanges like the Euronext 100 or OMX Nordic 40.
Sector: These indices target specific industry sectors. Examples include the Wilshire US REIT Index, which tracks real estate investment trusts, the NASDAQ Biotechnology Index, which focuses on biotechnology firms, and the S&P 500 Information Technology Index.
Another way to categorise indices is by their weighting methodology. This refers to the rules that determine how much influence each stock has on the overall index value, independent of the types of stocks included.
Market-capitalisation weighting: This is the most common method. It weights each stock by its market capitalisation (market cap), which is the share price multiplied by the number of shares outstanding. A market-cap-weighted index is essentially a reflection of investor sentiment towards larger companies, as they tend to have higher liquidity and can handle larger investment flows. However, this method can lead to concentration risk, where a few large companies dominate the index’s performance. The S&P 500 is an example of a market-cap-weighted index.
Free-float adjusted market-capitalisation weighting: This method refines the market-cap weighting by excluding shares that are not freely available for trading on the public market. These shares might be held by governments, company affiliates, founders, or employees. This adjustment helps investors understand the true liquidity of the index.
Price weighting: While relatively uncommon in modern index construction due to its limitations, this method assigns weight to each stock based on its share price relative to the total value of all the shares in the index. For instance, a stock split would decrease the weight of that stock in the index, even if the company’s fundamentals remained unchanged. This makes price-weighted indices less suitable for passive investment strategies. The Dow Jones Industrial Average is an example of a price-weighted index.
Equal weighting: This method gives each stock in the index an equal weight. While promoting diversification, this approach doesn’t favour any particular stock and can result in higher volatility and lower liquidity compared to market-cap weighted indices. The Barron’s 400 Index is an example of an equally weighted index.
Fundamental factor weighting: This method assigns weight to stocks based on chosen “fundamental factors” such as sales, income, or dividends, rather than just market data. This approach assumes that stock prices will eventually reflect these intrinsic factors.
Factor weighting: This method weights stocks based on their risk factors as identified by factor models. These models might consider factors like value, size, or momentum. Factor weighting is sometimes used in “smart beta” investment strategies.
Volatility weighting: This method weights stocks according to their historical volatility, with less volatile stocks receiving a higher weighting. The S&P 500 Low Volatility Index is an example of a volatility-weighted index.
Minimum variance weighting: This method uses a mathematical approach to weight stocks in a way that minimises overall portfolio risk.
Indices can also be calculated based on price returns or total returns (which include dividends). Total return indices provide a more accurate representation of an investor’s overall returns.
Investable
There are two key features most indices share: they are investable and transparent. The way an index is constructed is clearly defined, and investors can gain exposure to it by investing in an index fund. These funds, either unit trusts or exchange-traded funds (ETFs), are structured to mirror the performance of a particular index. Any difference between the performance of the index fund and the underlying index is known as a tracking error.
Frequently Asked Questions
How can I invest in an index?
Investors can gain exposure to indices through index funds, ETFs, index options, and index futures that track the performance of a specific index.
What is a tracking error?
A tracking error in a stock index fund is the deviation or difference between the performance of the fund and the performance of the benchmark index it is trying to replicate. It measures how closely the fund is able to track or match the returns of its target index over a given period.
What is the difference between stock market indexes and indices?
There is no difference between “stock market indexes” and “stock market indices” when referring to measures that track the performance of a group of stocks. They mean the same thing.
