Stock market indices are key to understanding financial markets. This Complete Guide will cover everything you need to know about Stock Market Indices. You will learn about market valuations, passive investments, and macroeconomic indicators.
- Index Creator
- Applications of Stock Market Indices
- How Stock Market Indices are Constructed
- How are Stocks Weighted in an Index?
Stock market indices, also referred to as equity indices, are frequently mentioned by the financial press to explain what is happening in the stock market. Stock indices are also used to create passive investment products, such as exchange-traded funds. And even politicians and central banks refer to stock indices to describe how the economy is doing.
In this guide, I will cover the most important things about stock market indices and explain how they work. That is everything you need to know.
A stock market index is just a group of stocks. In its simplest form, we could build a stock index by taking two corporations, like Apple and Google, and giving each of them a 50% weight. We could then reference this group or basket of stocks to describe how the index is doing. That would be a good representation of how Apple and Google are trading in the stock market.
Most stock indices, though, are somewhat more complex. They include more than two stocks, based on various eligibility criteria, and their weights are set according to certain rules.
Stock indices aim to represent a portion of the global stock market. Some examples would be the United States stock market being represented by the S&P 500, the stock market in the euro zone being represented by the Eurostoxx 50, the stock market of emerging countries represented by the MSCI Emerging Markets, or something as specific as German technology companies being represented by the TecDAX.
The S&P 500 includes about 500 stocks listed in the United States. It is a very good representation for large- and mid-cap stocks in the largest stock market in the world.
Similarly, the Eurostoxx 50 is a stock market index that represents 50 of the largest companies in the eurozone, such as Iberdrola, Allianz and LVMH.
2) Index Creator
All stock indices have a creator or owner behind. In other words, indexes are calculated and owned by companies. The index owner is responsible for constructing and updating the index on a regular basis, as well as calculating and publishing the index’s returns, along with other statistics that may be of interest to the financial community.
Most indices are owned by financial data companies or exchanges. Some of the largest financial data companies that own and calculate indices are S&P Dow Jones, MSCI, Bloomberg, FTSE Russell or Nikkei. Their indices include the S&P 500, the MSCI World, the FTSE100 or the Nikkei 225.
When it comes to stock exchanges, most of them own and calculate stock market indices. Some of their indices include the Nasdaq Composite, the German DAX, the Japanese TOPIX or the Spanish IBEX 35.
3) Applications of Stock Market Indices
As you can imagine, stock indices are created to make money. Although it may seem counterintuitive to many people, indexes are not simply created for the press to talk about.
Creating and maintaining an index is expensive, and the level of regulation is very high. Financial authorities closely monitor how index companies work and disclose information. This is because trillions of dollars of investors’ money are dependent on these indices.
Simultaneously, stock market indices determine investment flows and affect the level of compensation for many investment fund managers.
Let us discuss how stock index owners make money, and why it is so crucial for everyone in the financial markets to make sure index numbers are always accurate.
3.1) Passive Investment Products
Stock indices are used to build passive investment products. These products allow investors to invest in the markets of their choice without having to select individual stocks. The most important passive investment products are exchange-traded funds, index funds, stock index futures, and investment certificates.
These types of investments have become tremendously popular over the last few decades. They have made it possible for millions of investors around the world to access global equity markets easily and at very low costs.
The managers of these passive funds are responsible for tracking a stock index as accurately as possible. This shows the importance of good and correct data.
3.2) Benchmark for Active Investment Funds
Active investment funds have the goal to outperform the stock market and also use equity indices. A stock index is used as a reference universe for what the fund will be investing in and trying to outperform. The index is known as the fund’s benchmark
The benchmark chosen must correctly represent the market around which assets will be invested.
For example, an active investment fund of US stocks could use the S&P 500 or the MSCI USA as its benchmark index, since both represent the broad US stock market. However, using the MSCI World would be incorrect as it includes hundreds of non-US stocks.
The benchmark index is used to assess how well the fund manager has done. The goal is to outperform the index. If the index falls by 20%, but the fund only loses 10%, the manager has done a very good job.
Similarly, if the index goes up by 20%, but the fund’s return is only 10%, that would be a very poor job from the manager. The performance of an active fund always has to be considered relative to the benchmark index.
Often, the fees that investors have to pay will be dependent on how good the performance is. The better the performance, the higher the fees and the higher bonus that the fund manager will receive. This is done to align the interests of investors and the fund managers.
3.3) Analyze Historical Stock Market Performance
Finally, stock market indices are also used to study how different stock markets have behaved in the past. We can use them to measure things like historical performance, volatility, drawdowns, or the correlation of an index with other indices or asset classes.
By analyzing various indices representing the stock market, the bond market, commodities, gold and other asset classes, we can build diversified portfolios that are able to withstand most macroeconomic scenarios.
In this sense, stock market indices are used to assess what kind of return and risk we can expect from investing in the stock market. Though always remember that past performance is not indicative of future performance.
4) How Stock Market Indices are Constructed
The three most important elements to understand how a stock index is constructed are its eligibility criteria, how indices are rebalanced on a regular basis, and how stocks within an index are weighted:
4.1) Eligibility Criteria
Every stock index has a methodology to decide what companies will be included in the index. Many things are considered, including a company’s market capitalization, where its headquarters are located, the number of daily stock transactions, its sector, its profitability, growth, if there have been accounting scandals, if a government owns a portion of it, etc.
Eligibility criteria have to be met for a company to be included in an index. For example, it took a very long time for Tesla to join the S&P 500, even though it was already one of the largest companies in the world by market capitalization.
This is because one of the criteria that S&P uses to choose which stocks will be part of the index is that a company has have had profits for a certain number of quarters in a row. Tesla was only included in the S&P 500 once it had accomplished that.
As you can see, eligibility criteria are more important than many may think. They determine whether a company will be part of an index or not.
4.2) Stock Index Rebalancing
Another fundamental aspect is to understand how an index is updated or rebalanced. This is about how often and by which process indices get updated.
Stock market indices are generally updated quarterly, semi-annually or annually. Whenever that happens, new companies may enter the index, while old companies may exit the index. As a result, the index will have a different set of companies over time.
Although these changes may seem unimportant on a day-to-day basis, they inform us about how the economy and the stock market have changed throughout history. For example, the Dow Jones Industrial Average, one of the oldest stock market indexes, was launched in 1886. None of its original stocks is part of the index nowadays as both the economy and the stock market have gone through radical changes.
At the same time, it is important to understand whether indices are rebalanced based purely on numerical criteria and rules, or whether qualitative aspects are also considered.
The methodology of some stock indices defines very clearly which companies should be included and when. There is no human intervention in the rebalancing process.
On the other hand, some indices have a committee of experts that decides how the index should be updated. If we go back to the Dow Jones Industrial Average, its goal is to choose 30 companies that are representative of the American economy.
Due to the transformation experienced by the American economy over the last few decades, this committee has decided to include more technology companies to the detriment of banks and energy companies, two sectors whose weight in the economy and the stock market has declined over time.
5) How are Stocks Weighted in an Index?
The third element to understanding how stock indices are built is to know how the weights of different stocks are determined. Since not all companies are equally important, we will most likely want to use a methodology that reflects that. This is a key aspect of this guide to stock market indices.
Understanding the composition of an index is necessary before we commit our capital. For example, if we want to invest in a certain country or region through an ETF, we need to know the weight of different sectors and companies in it.
For example, the most famous stock market index in Switzerland is the SMI. Though it is composed of 20 stocks, 3 of them represent an aggregate weight of 50%: Nestlé, Novartis and Roche. The other 50% is allocated among the other 17 stocks. We may be fine with that, but it is something we need to be aware of before investing in Switzerland.
There are different methodologies that are commonly used to decide the weight of stocks within an index.
So that you can better understand the implications of each of these methodologies, we will take four American stocks and build indices using different methodologies. The table below includes (approximate) information about each of these stocks. The goal is to illustrate how the profile of an index changes depending on which weighting methodology is used:
5.1) Market Capitalization
The market capitalization is the market value of all the shares of a company. This is often used to describe how much a company is worth. It also indicates how large a company is in the stock market.
For the purpose of index construction, the more a company is worth, the greater its weight in the index. In the case of our fictitious 4-stock index, the weights for each of the companies would be the following:
As you can see, this index would be strongly dominated by Apple and Microsoft, since they have the largest market capitalization.
Although this methodology is not bad, it is not the most optimal, as we will see next.
5.2) Free Float Adjusted Market Capitalization
Free float-adjusted market capitalization is the most widely used methodology for constructing stock indices. The free float is the number of shares that are available to investors on the stock market. In other words, it does not take into account the company’s shares that are in the hands of large shareholders, traditionally founders or governments.
The reason why this methodology is the most popular is because it takes into account the size of each company but adjusting it by reflecting how investable it actually is.
For example, one of the largest companies in the world is Saudi Aramco, Saudi Arabia’s largest oil producer. The stock is traded on the Riyadh Stock Exchange. However, its weight in global stock indices is quite small.
The reason for that is that 95% of the shares are in the hands of the Saudi government. Therefore, while the company is indeed large, the availability of shares for stock investors is small. In the case of Saudi Aramco, the free float adjusted market capitalization is way smaller than its total market cap.
The weights of our fictitious index based on the free float adjusted market cap methodology would be as follows:
As you can see, the weights of each of the companies would not change dramatically.
One of the great advantages of indices whose weights are based on the market capitalization of companies, regardless of whether they are adjusted for free float or not, is that they are not affected by stock splits.
Some indices determine the weights of its companies based on their stock prices. This methodology is extremely simple. That is the reason why the oldest stock market indices were built this way.
A price-weighted stock index assigns larger weights to companies whose stock price is higher. And lower weighs to companies whose stock price is lower. Therefore, a stock trading at $200 will have double the weight as a stock trading at $100.
As you can imagine, this methodology does not consider any intrinsic characteristic like a company’s size, growth rates or dividend yields. The price of a stock says very little about a company and can be adjusted by the company itself by doing splits or counter splits.
Because of that, stock indices that are price-weighted are not a very good indicator of what is happening in the broad stock market. Despite that, two of the commonly quoted stock indices are price-weighted: the US Dow Jones Industrial Average and the Japanese Nikkei 225.
If we were to use this methodology, our fictitious index would look like this:
As you can see, Microsoft would be the stock with the largest weight. Interestingly, although JP Morgan and Exxon Mobil are significantly smaller than Apple, their weight would be quite similar.
Another problem with this methodology is that weights get affected by splits. An example was Apple in the summer of 2020. It split its shares into 4. Therefore, investors suddenly owned 4 times as many shares, but the new stock price was one fourth of the pre-split stock price. Even though the company had not changed in any way, Apple’s weight in the Dow Jones index also went down by 75%.
5.4) Equal Weight
Some indices assign an equal weight to all stocks, regardless of their size or characteristics. One example is the S&P 500 Equal Weight.
These indices tend to be dominated by small companies. The reason for that is because there are many more small companies than large ones.
Equal weight indices are a good indicator of what is happening with all stocks that are listed on a stock exchange, without the movement of a few mega corporations determining the direction of the market.
As you can expect, our fictitious index would look like this if we were to use equal weights for each stock:
5.5) Alternative Methodologies
Finally, alternative methodologies can also be used to determine index weights. How stock indices with alternative weighting methodologies work depends exclusively on the creator of the index.
Such indices are usually created with the goal to represent certain investment strategies. Some examples would be weighting stocks based on their P/E ratio, sales growth or dividend yield.
They can also have more complex rules. For example, they could be based on several metrics at the same time and use a formula to determine how important each of these metrics is.
We can see how our fictitious index would look if companies were weighted according solely to their dividend yield:
As you can see, despite being much smaller in terms of market capitalization, Exxon and JP Morgan would dominate this index thanks to having higher dividend yields than Apple and Microsoft.
As you can see, knowing how indices work is a requirement to understand the broader financial markets. This is why I prepared this guide to stock market indices.
Stock indices can be very heterogenous and be used for many different applications. Consequently, whether you are considering investing in an ETF or analyzing the markets, if you are look at a stock market index, make sure you understand how it is constructed.
This will make it possible for you to build a globally diversified portfolio with just a handful of ETFs.
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