“The Dow hits an all time high”. “US Market Indexes start the week with gains”. “Nasdaq exits bear market as stocks rally”. You may have read similar headlines in the newspapers and heard them on evening news. But what exactly is a market index?
A market index is a collection of securities with characteristics defined and computed by the index provider. The S&P 500, for example, represents a market-weighted aggregate of 500 largest stocks traded in the United States. There are many index providers – MSCI, Russell, Moody’s, Dow Jones, etc.
There are several uses of an index. The most obvious one is to track how the broad market or a component of the market represented by the index is performing on any given day or period of time and compare an individual portfolio relative to it.
Another use is for managers to create index funds and exchange-traded funds (ETFs). These funds track the performance of the underlying index using a passive approach.
Economists, portfolio managers, and investors can use market index movements to study risk. More on this in another article!
Index creation
There are different ways indexes can be created. The Dow Jones Industrial Average (DJIA) index is a price-weighted index. The S&P 500 is a value-weighted index.
Price-weighted Index
Simplistically, a price-weighted index is an arithmetic mean of current prices of all securities in the index. A stock with a higher price will have more influence over the value of the index. Here’s an example. Say, a price-weighted index is composed of 3 stocks, A, B, and C. Ten days ago, the stocks traded at $100, $70 and $10 respectively. Let’s consider two case scenarios as of today. In case 1, stock A has a price increase of 10% with no change in the prices of the other stocks. In case 2, stock C has a price increase of 10% with no change in the prices of the other stocks.
| Stock | Price 10 days ago | ||
|---|---|---|---|
| Case 1 | Case 2 | ||
| A | $100 | $110 | $100 |
| B | $70 | $70 | $70 |
| C | $10 | $10 | $11 |
| Sum | $180 | $190 | $181 |
| Divisor | 3 | 3 | 3 |
| Index Value | 60 | 63.33 | 60.33 |
The index changed by 5.55% in the first case and in the second case, only by 0.55%, even though in both cases there was one stock that had a 10% price increase.
If there is a stock split or a reverse stock split in any component of a price-weighted index, the divisor needs to be adjusted.
The DJIA is a price-weighted index comprised of 30 blue-chip companies. The prices of 30 securities is summed on any given day and divided by a divisor that is adjusted each time there is a stock split.
Value-weighted Index
A value-weighted or capitalization weighted index has stocks weighted according to their market capitalizations. Market capitalization is the product of price of the stock times the outstanding shares. The most popular beginning value or base for a value-weighted index is 100. On any given day, the index value is then equal to total market capitalization of stocks in the index on that day divided by the total market capitalization on base day multiplied by the beginning index value.
Let’s consider a 3 stock example to understand the index value calculation. Our index comprises 3 stocks – A, B, and C and the index began on December 31, 2017 with a beginning value of 100. In this case, we assume that the number of outstanding shares does not change.
| Stock | Share Price | Shares Outstanding | Market Cap | Share Price | Shares Outstanding | Market Cap |
|---|---|---|---|---|---|---|
| A | $100 | 20,000 | $2,000,000 | $110 | 20,000 | $2,200,000 |
| B | $50 | 20,000 | $1,000,000 | $50 | 20,000 | $1,000,000 |
| C | $200 | 10,000 | $2,000,000 | $200 | 10,000 | $2,000,000 |
| $5,000,000 | $5,200,000 | |||||
Index value on December 31, 2018 = 5,200,000 * 100/5,000,000 = 104.
A value-weighted index does not come without flaws. Similar to a price-weighted index that has a strong price bias, in a value-weighted index, a stock with the highest market cap has the greatest influence in the movement of the index.
Unweighted index
All stocks, regardless of market capitalization or price, carry equal weight in an unweighted index. Each stock can influence the movement of the index equally.
Style indexes
There are many different indexes based on stock characteristics such as the price to earnings, price to book, etc., and size such as large cap, mid cap, small cap, etc. Six basic style indexes arose from these type and size characteristics – large-cap growth, large-cap value, mid-cap growth, mid-cap value, small-cap growth, and small-cap value.
Factor indexes
With the rapid rise of passive investing, there has been a lot of innovation in the index world. More recently, indexes with a focus on environmental, social and governance (ESG) have become popular. Additionally, there are many indexes with a focus on single factors such as low volatility, momentum, value, quality and low beta and multi-factor indexes that combine some or all of those factors and more.
It is important to choose the right index as a benchmark in order to see how your portfolio performed over a given period. The index must be consistent with your investing universe. If you invest in international stocks, your benchmark cannot be the S&P 500. A selection of an appropriate benchmark is essential in evaluating the true relative performance of your portfolio.
Click here to learn stock market basics.
Happy Investing!
