Security Market Indexes

A security market index is a means to measure the growth of value of a set of securities. Sometimes, an index is just an arithmetic average, but, usually, it is a ratio where the current index value is divided by the index value of some base year — the base market value. Although this value is usually measured in dollars, the dollars cancel out in the ratio, so such an index is a pure number that is a multiple of the base figure. Some famous indexes are the Dow Jones Industrial Index (DJIA), which is a group of 30 stocks of the largest American corporations, the Standard & Poor's Composite 500 Index (S&P 500), which comprises about 500 stocks, and the NASDAQ Composite Index, started on February 5, 1971 with a base value of 100, comprises most of the stocks on the NASDAQ trading system, and consists of many technology companies.

Some famous international indexes include the DAX (Germany), Hang Seng (Hong Kong), FTSE (U.K.), Nikkei (Japan), and TSX (Canada). Morgan Stanley Capital International (MSCI) constructs many of the leading international indexes.

Most major stock indexes also have subindexes, which measure the growth of particular sectors. For instance, the NASDAQ Composite consists of the following subindexes: Bank, Biotechnology, Computer, Industrial, Insurance, Other Finance, Telecommunications, and Transportation.

To accurately measure the growth of a market, an index must have a sufficient sample size of securities which are representative of the particular market that the index seeks to measure. Weighting of each component of an index is another consideration. Most stock market indexes, for instance, are weighted by market capitalization, which is the stock price multiplied by the number of shares outstanding.

Advantages of Market Indexes

Indexes can be used not only to see how the stock market, for instance, has increased over time, but it allows easy comparison between securities that represent different sectors or even different securities. For instance, how well did value stocks compare to growth stocks? How do large-cap stocks compare to mid-cap and small-cap stocks. How do stocks compare to bonds as an investment?

Another advantage of indexes is that it is easy to see how they correlate with each other. Investors can reduce their risk by investing in different securities that either have no correlation or a negative correlation with each other. Thus, when one investment is up, the other is down, and vice versa. Stocks and bonds, for instance, have a slightly negative correlation.

It is easy to measure the volatility of a particular sector by measuring the standard deviation of its index. The greater the standard deviation of the index, which measures the volatility of the sector measured by that index, the greater the investment risk withn a short duration.

Another important use for an index is to see how well money managers are earning their keep. For instance, mutual funds are pools of investors' money that are actively managed to profit from investments, and the managers charge a fee, sometimes a pretty hefty fee, for their services. But how well are they doing? If a stock fund isn't doing better than the S&P 500, then someone, even without any investment experience, using a naive buy-and-hold strategy, could simply buy all the stocks that compose that index, mirroring the same weight as the index, or an equivalent exchange-traded fund, and do better than the fund managers with all their knowledge and resources that they have available. So if the money manager can't do better than an index, the money manager has no real value, and fees should be minimal. In fact, it is because very few managers beat the indexes, that index funds and exchange-traded funds have become so popular. By doing away with active management and the associated fees, these funds charge the lowest fees, and therefore, generally yield the highest returns, because high fees subtract from the returns that investors can earn from a fund.

Index Weighting

There are 3 common index weightings: market capitalization, price, and equal weighting.

Market capitalization weighting (also, value weighting) easily accommodates stock splits and stock dividends, because they do not change the market capitalization of the company, and therefore, the weighting in the index. The market cap is computed by multiplying the share price times the number of shares outstanding.

Market Capitalization Formula
Market Cap=Share Price × Number of Shares Outstanding

A portfolio based on market capitalization weighting would have more money invested in larger companies. For instance, the S&P 500 index, which is a market capitalization weighted index, is calculated by adding up the current market capitalization of each company, then dividing by the market capitalization of each company in the base years 1941-1943, then multiplying the result by 10. However, this weighting often leads to less diversification because a few large-cap stocks dominate the index. It can also lead to lower returns because large companies generally have a lower growth potential than smaller companies.

Price weighting is based on the prices of each stock. A price-weighted portfolio would have the same number of shares of each stock. Price weighting = the sum of the prices of each individual stock in the index divided by the number of stocks. When there are stock splits or dividends, the divisor must be adjusted; otherwise, the index would not measure actual growth. For instance, if there were 2 companies composing an index with the stock of each priced at $100, then the average price is their sum divided by 2, which is $100. However, if one company has a 2-for-1 stock split, then its stock will be priced at $50 per share (the number of shares will also double), then the average becomes (100 + 50)/2 = 75, even though the size of each company and its market value has not changed. To keep the average the same, the divisor must be changed accordingly.

Example: Finding New Divisor for Price Average after Stock Split or Dividend
New Sum of Share Prices/D = Old AverageLet D = new divisor.
150 = 100 × DMultiply both sides by D
150/100 = DDivide both sides by 100.
D = 1.5The new divisor = 1.5
(100 + 50)/1.5 = 100Verification: The average stays the same.
General Formula: New Divisor = New Sum of Share Prices/Previous Average

For instance, the Dow Jones Industrial Average first consisted of 30 stocks in 1928, and had a divisor of 30. In 1999, the divisor was .19740463 — the divisor will continue to get smaller as there are more stock splits and stock dividends. (However, it could temporarily increase if there is a reverse stock split, where a number of shares are merged into one share, as sometimes happens when the stock price has fallen too much.) Because the DJIA consists of only 30 stocks, it is not representative of the stock market. However, it persists for historical reasons. Only a small number of stocks were considered because when the DJIA was started in 1884 with 12 stocks, it was time consuming to figure such averages every day without the aid of computers or calculators. The number of stocks was increased to 20 in 1916, then to its present 30 in 1928.

Equally weighted indexes simply gives each stock an equal weight, regardless of stock price or market capitalization, so, obviously, stock splits and stock dividends will not affect an equally weighted index. An equally weighted portfolio would have the same amount of money invested in each unique stock. Therefore, the number of shares of each stock would differ, with more shares of cheaper stocks. An equally weighted portfolio must be rebalanced more frequently to maintain equal weight, because stocks prices would diverge quickly.

An equally-weighted index will be more diversified than a value-weighted index, because it will not be dominated by large companies, so investments based on an equally weighted index may have higher returns, since small companies generally have a greater growth potential than large companies.

Substitutions in the Index

One problem with all indexes is that substitutions are required sometimes, because companies can disappear through mergers, acquisitions, they can simply become insolvent, or they can be taken private. Substitutions are also necessary when a company no longer satisfies the requirements for index inclusion. For instance, when a company is delisted from a stock exchange, it is generally excluded from the S&P 500 index. A company listed in the Russell 2000 index may simply become too big to be included in that index — then it moves up to the Russell 1000 index and the Russell MidCap Index. Changing the composition of an index is called rebalancing, or reconstituting the index. Rebalancing occurs periodically, depending on the index. The Russell indexes are rebalanced every year in June, for instance, and IPOs are added quarterly.

Because changes in companies are occurring constantly, but indexes are only rebalanced periodically, index numbers usually only approximate the number of securities in the index. For instance, the S&P 500 probably will not have exactly 500 stocks in the index, nor will the Russell 1000 have exactly 1,000 stocks. The Wilshire 5000 index actually is benchmarked to about 7,000 stocks.

Substitutions can also cause price changes in the other stocks of the index. Funds that track a market-weighted index, such as the S&P 500, have a certain amount invested in the index. If large market cap stocks leave the index, for whatever reason, then their replacement stocks will probably have a lower market capitalization. Therefore, not only will the stocks entering the index receive a price boost, but other stocks in the index may also receive a boost, since the funds that are tracking the index will probably want to maintain the same amount of cash invested in the index, which will be distributed according to the new capitalization profile of the index. (Example: Taking Stock: How Buyouts Alter the S&P - WSJ)