How Indices Work?

What Is A Stock Market Index?

An index measures a specific stock market or part of it continuously which helps investors assess current prices and performance versus previous ones. Indices are made up of the prices of several stocks and each has its own method of calculation.

Some indexes focus on a smaller part of the market. For example, there exist indices that focus only on the automotive sector in the USA while another index exists that tracks top dividend-paying stocks around the world. They also vary in size according to their coverage. The S&P 500is made up of the 500 largest corporations in the US while other indices may only contain a handful of stocks.


Weighting Method Of Indices

There are different ways that stock indices are created and priced. The most common one is the Market capitalization calculation but price-weighted and equal-weighted also exist, among others.
Let’s look at some of the methods:

Market-cap weighted

This is calculated based on the market cap of each stock which is the number of outstanding stocks multiplied by the current price. In this case, larger companies will have more weight in the index, and changes in their price will affect the index much more than smaller companies and their price variations. For example, the S&P 500 (Figure 1) is a market-cap weighted index but there also exists an S&P that is equally weighted, meaning all companies within it carry the same weight.

Price weighted

This is calculated by using the stock’s price per share divided by the sum of all the prices within the index. Famous examples of this method including the Dow Jones Industrial Average and the Japanese Nikkei 225. Although not the most trustworthy method of gauging the stock market’s health, the correlation with more significant indices along with their popularity makes price-weighted indices a go-to index for day-to-day movements.




Equal Weighted

Indices with an equal weighting mean each stock is given a weight of 1/x where x represents the total number of stocks in the index. Again, this approach might distort the bigger picture, giving small-cap stocks more spotlight and reducing the significance of large-cap companies. It’s not a common calculation for indices but the Barron 400 Index is a well-known example of 400 stocks where each weighs 0.25%.

Volatility Weighted

This is calculated by taking into consideration the volatility of a stock usually calculated as the standard deviation over 1 calendar year equating to around 252 trading days. The other calculation is a weekly standard deviation over 3 calendar years.


Major Stock Indices

The top 3 stock indices in the US and the world are:

Dow Jones: 30 of the largest and most significant US companies make up the Dow Jones index. It’s a price-weighted index and its holdings do not change very frequently.
S&P 500: The 500 biggest companies across different sectors, weighted by market cap. The S&P 500 is a good indicator of the performance of the stock market and the entire economy.
Nasdaq: Includes around 3000 companies that are part of the Nasdaq exchange with an emphasis on technology stocks.

Beyond those three, there exist thousands of indices spread across most countries of the world. Some indices may track the stock market of major trading centers such as Sydney or Tokyo while other indices might focus on a specific sector or industry. There’s nearly an index for every style or requirement and traders and investors will always be able to see how an idea or strategy might perform.

Other Indices

Nasdaq 100: Focuses on the 100 biggest in the Nasdaq exchange and excludes financials. This index is geared towards tracking the performance of the tech sector.

Russell 2000: The Russell 2000 is made up of 2000 small-cap companies and shows how the smaller companies across the US are performing. It occasionally disconnects from other major indices but in the long run, it tends to outperform larger companies.

Russell 3000: One of the most comprehensive indices available, the Russell 3000 includes the Russell 2000 and the Russell 1000 which contains the stocks of the largest 1000 companies. It’s truly a gauge of the entire US market.(Figure 2)

S&P 500 Growth Index: The focus is on stocks with potential growth characteristics such as higher than average sales and higher price to earnings ratio. The stocks in the S&P 500 Growth Index include Apple, Amazon, Facebook, and Visa among others.

S&P MidCap 400: This index includes stocks between $1.6 Billion and $6.8 Billion in market cap. Usually, mid-range stocks are seen as a good tradeoff between the volatility of small-cap stocks and the limited possible returns of large-cap stocks.

S&P SmallCap 600: Another index that tracks 600 small-cap companies but the Russell 2000 is more widely watched and traded for its wider small-cap exposure.



Index Investing

Indices can come in handy in different situations. For example, let’s say you’re looking to get a better understanding of the entire market. All you need to do is analyze one of the top indices which will give you an idea of its historical performance as well as current prices. This is beneficial for those looking to create a diverse portfolio or invest broadly.

Indices are known for being used as benchmarks and not just as a gauge of the stock market or an economy. In other words, mutual funds, exchange-traded funds, and even hedge funds, and other types offering a ready portfolio to clients might back-test and assess returns against major indices. Others may already have an established and running portfolio and would choose to do the same by posting ongoing returns and comparing them to certain indices.

This is ideal for investors who are looking for the right product and have watched the markets for a while. Instead of investing in the components of the S&P 500, an investor may look to buy an ETF that closely tracks the S&P 500 with minor variations that have historically yielded better returns. The customizations and the variables involved can be endless.

Furthermore, investing in indices is considered a low-maintenance passive investment. It’s straightforward and investors either buy the components or buy derivatives that track that specific index. This is in contrast to portfolio managers who are constantly rebalancing holdings, rotating into different sectors, and keeping an eye out for potentially bad news on heavily weighted stocks that could affect the portfolio.

Indices can come in handy in different situations. For example, let’s say you’re looking to get a better understanding of the entire market. All you need to do is analyze one of the top indices which will give you an idea of its historical performance as well as current prices. This is beneficial for those looking to create a diverse portfolio or invest broadly.

Another advantage lies in the availability of smaller indices that can focus on a specific segment, sector, or industry in a market. For example, some indices track dividend-paying stocks which can be useful for investors looking to hold stocks that have consistently paid dividends over the years.

Investing in products that track the performance of major indices gives you broad customization to build the portfolio you believe will create good returns without having to maintain or reposition periodically.

On a final note, the financial markets are interconnected which means that Stock indices may affect the flow of money across other markets so learning how assets are correlated can give you great insight into what to expect for other products you might be interested in trading.