Market Indexes are a powerful tool for investors to use when trying to gauge the health and wellness of global, or country specific, economies. In the case of the US, the most broadly followed indexes are the Dow Jones Industrial Average, the S&P 500, and the Nasdaq composite. In addition to those three, there are also thousands of other indexes available in the US and tens of thousands available around the world.
Table of Contents:
- What is an index
- Price Weighted vs Market Weighted Indexes
- Index examples
- Dow Jones Industrial Average
- S&P 500
- Nasdaq Composite
- Other Index Funds to Know
What is an Index?
An index is simply a subset of the market that helps investors compare and contrast different things. The usual comparison that is made with indexes is to look at the past performance of the stock market or to compare the performance of two subsets of the market (i.e. comparing the technology sector to the energy sector).
Indexes may be broad based in an effort to capture the market as a whole, or they may be more segmented to try to capture certain aspects, or components, of a market. To provide more context, I created the infographic below.
Generally speaking, indexes serve as the most prevalent way to benchmark the performance of a portfolio. Have you ever heard of the active vs passive investing debate? That debate has raged for years, and is something that Warren Buffett bet $1 million on. Ultimately, the debate centers around whether active investors are able to outperform an index in the long run (i.e. do hedge funds make sense?).
Interestingly though, you cannot invest directly in an index. Indexes serve only as a hypothetical subset of stocks, and are not investable. To invest in an index like product you need to invest in an index fund. An index fund is typically an etf or mutual fund that seeks to match the performance of the index that it mirrors.
Price Weighted vs Market Weighted Indexes
There are many different index methodologies available today. Of the different variations available the two most commonly used are price weighted and market weighted indexes.
Price Weighted Indexes
A price weighted index is one where the trading price of the index is based on the trading prices of the individual securities in the index. In price weighted indexes the securities that make up the index are known as components and are weighted in proportion to their share price and not one of the other factors.
How Does a Price Weighted Index Work?
Let’s assume that the following companies make up the ABC price weighted index:
Since a price weighted index is simply the sum of the share prices of the members stock divided by the number of members, we can easily determine the index value. In this case, the value of our index is $7.20
In a price weighted index, the securities, or components, with a higher share price will have a larger impact on the index, regardless of any other factor. That means that if your index contains Apple (roughly $400 a share) and Berkshire Hathaway Class A (roughly $300,000 a share) the way the weighting works will give Berkshire Hathaway roughly 750 times more weight than Apple – even though Apple is a bigger company by any other metric.
The impact of higher share prices having higher impact is dynamic though. As the index goes through rebalancing periods the weight that each security has will change. Occasionally, securities will be added or dropped from the index as well based on weighting and methodology for choosing components.
In the above example, assume that Berkshire Hathaway’s stock was to significantly lose value, or that Apple’s stock was to significantly gain value. During the rebalancing period the weight of the index would shift from Berkshire Hathaway to Apple.
More complex price weighted indexes use what is called a divisor to adjust the index for things like spinoffs, mergers, and stock splits that would otherwise impact the composition. The divisor is simply an adjustment to the denominator of the index (as the name suggests) so that it can better manage these unforeseen events.
Bret’s Take: It’s not hard to see the downsides to price weighted indexes, but they do serve some value. The Dow is probably the most recognizable index in the world and it is price weighted. The reality is that even if you recognize the pitfalls, adjust the divisor appropriately (if you are using one), and select your components appropriately you can create a price weighted index that serves a purpose.
Market Weighted Indexes
Market weighted indexes are much more popular in today’s investing environment. A market weighted index is one where the trading price of the index depends on the market capitalization of the securities in the index. Most market weighted indexes are broken down into sectors that contain individual securities that are similar.
How Does a Market Weighted Index Work?
Let’s assume that the following companies make up the ABC Market Weighted Index.
Since market weighted indexes are calculated by taking the market capitalization of the companies we need to multiply the total shares outstanding of each security by its trading price to get the capitalization of the index as a whole. Once we know the individual market capitalizations we can add them to get the index capitalization. In the case of DEF Market Weighted Index, our market capitalization is $218,500.
Market weighted indexes include more than just price, they include the shares outstanding and ultimately the market capitalization of the securities to derive an index capitalization. This is a much more realistic way to derive an index because you remove the skew of companies that may have a high share price, but a low market capitalization.
Like price weighted indexes, market weighted indexes are also rebalanced occasionally. This rebalancing allows for the weighting of each security to change periodically. The rebalancing also allows for new securities to be added and old ones to be removed as needed.
Market weighted indexes are not without downfalls, though. Market weighted indexes can still end up containing one or two companies that make up an excessive amount of the index, but it is more challenging given the more complex design.
Bret’s Take: Market weighted indexes are the way to go in my book. There are way more inputs to be considered than just price and market weighted indexes allow you to take some of that into account.
Dow Jones Industrial Average (The Dow, or DJIA)
The Dow Jones Industrial Average, or Dow for short, is one of the oldest and most recognizable indexes in the world. It is frequently used in conversations regarding US stock prices and as an investor you have undoubtedly heard someone quote what the Dow was trading at.
What is it?
The Dow Jones is without a doubt the granddaddy of all indexes. Founded in 1885 by Charles Dow, the Dow is a price weighted index that originally contained 12 stocks, all of which were some form of transportation or industrial company.
Fast forward to today and the Dow has grown from 12 to 30 of the largest and most influential companies in the US. As it stands today, the Dow represents roughly 25% of the entire US market.
As with any price weighted index, a move in the Dow should not necessarily be thought of as a move in the stock market as a whole. Because the Dow is price weighted, and only contains 30 companies, it tends to suffer from a lack of diversification and an overly simple methodology.
The Dow being a smaller, price weighted index, does not mean that it serves no value, though. Many people follow the index because it contains companies that are considered to be “blue chips.” Blue chip companies are very well-established companies that offer consistent dividends. With this, the Dow is a relatively good indicator of how large cap, blue chip, companies are performing.
How Does it work?
Where most other indexes have a formal selection methodology, the Dow is more subjective. The members of the Dow are selected by the Editors of The Wall Street Journal. The intent of the editors is to choose 30 companies that are very well established and are leaders in the market.
Companies within the Dow are called components and are able to hold their spot in index as long as they remain relevant. Interestingly, there is not a single company that has held a spot in the index for its entire existence. The longest running tenor was GE, who held a spot for 110 years before being dropped.
Dow Components (as of August, 2020)
- American Express
- Chevron Corporation
- Cisco Systems
- The Coca-Cola Company
- Dow Inc
- Goldman Sachs
- The Home Depot
- Johnson & Johnson
- JPMorgan Chase
- Merck & Co
- Procter & Gamble
- Raytheon Technologies
- The Travelers Companies
- UnitedHealth Group
- Visa Inc
- Walgreens Boots Alliance
- The Walt Disney Company
The Standard and Poor’s 500 index, or the S&P 500 is something every investor should know. It is frequently the topic of conversation on CNBC and is commonly used as a reference point for the US economy as a whole. While the value of the Dow is quoted more commonly, the S&P is actually a better indicator of the economy as a whole.
What is it?
The S&P 500 is an index that was developed in 1957 by, you guessed it, Standard and Poor’s. It comprises the 500 largest publicly traded American companies. In total, it captures about 80% of the total value of the US stock market and it is a very good indicator for the market as a whole.
How Does it Work?
The 500 companies that make up the S&P 500 are divided into 11 sectors and weighted by market capitalization. Each sector contains companies that are in the same or similar industries to one another.
The way that the S&P 500 is composed of various sectors and then rolled together in the form of a market cap index makes it very easy to duplicate with ETFs, which is part of the reason it is so popular. Another reason it is popular is because it captures such a large percentage of the US stock market as a whole, so when investing in the S&P 500 you are able to diversify very easily and capture a broad range of companies.
To choose which stocks are listed in the S&P 500 a committee looks at the liquidity, size, and industry of companies. Specifically, to qualify for the S&P 500 a company must:
- Be listed in the United States
- Have at least 50% of its fixed assets and revenues in the United States
- Have an unadjusted market cap of at least $8.2 billion
- Have at least 50% of the companies’ stocks available to the public
- Have a stock price of at least $1 per share
- File an annual 10-K report
- Finally, a company must have at least 4 consecutive quarters of positive earnings
S&P 500 Sectors (as of August, 2020)
The S&P 500 is broken down into the 11 sectors below. Each sector is then weighted based on market capitalization of the companies in that sector, meaning that companies and sectors with a higher market cap have a higher weighting in the index as a whole.
The Communication Services sector contains companies involved in communication such as social media, traditional media, cable, landline, and cell phone carriers. Examples of Communication Services would be Facebook, Disney, and Comcast.
The Consumer Discretionary sector contains companies that see their demand fluctuate based on general economic themes and conditions such as automobiles, hotels, restaurants, retailers, consumer durable goods, and others. Examples of Consumer Discretionary would be Amazon, Nike, Ford, and Hilton.
The Consumer Staples sector contains companies whose products we buy all the time like food and beverage and personal products. Examples of Consumer Staples would be Pepsi, Costco, and Proctor and Gamble.
The Energy sector contains companies that explore, produce, and sell oil and gas and the companies that supply equipment and materials to the oil and gas companies. Examples of Energy companies would be Exxon Mobil, Kinder Morgan, and Chevron.
The Financials sector includes banks (both commercial and investment), lenders, and insurance companies. Examples of Financials are Goldman Sachs, Geico, and Discover Financial.
The Healthcare sector includes hospitals, drug makers, biotech, and life science companies. Examples of Healthcare would be United Health and Bristol-Meyers.
The Industrial sector includes a wide range of manufacturing and transportation companies including airlines, railroads, machinery and defense. Examples of Industrials are Boeing, General Electric, and Delta Airlines
The Materials sector includes a number of different materials manufacturing companies including pulp and paper, metals, chemicals, and mining. Examples of Materials companies are Newmont Mining, Dow, and International Paper.
The Real Estate sector includes real estate development and management companies as well as Real Estate Investment Trusts (REITS), that were previously held in the Financial Sector. Examples of Real Estate companies are Public Storage and Simon Property Group
The Technology sector includes companies that make and sell computer hardware, software, and other components. Examples of Technology companies are Apple, Intel, and IBM
The Utilities sector includes companies that supply and produce electricity, water, natural gas, and renewables. Examples of Utilities are Dominion Energy, Pacific Gas and Electric (PG&E), and Public Service.
The Nasdaq Composite, or Nasdaq for short, is the third most recognizable index in the US. If you watch CNBC, or any other market news channel, on a regular basis you will hear them mention the trading price of the Nasdaq. This is especially true during the recent COVID-19 outbreak. Given the components of the Nasdaq, it rebounded much quicker than the S&P 500 and the Dow, making it a frequent topic of conversation.
What is it?
The Nasdaq Composite was developed in 1971. It contains roughly 2,500 securities, or almost all of the stocks that are listed on the exchange. Of the 2,500 securities listed, roughly 50% are technology companies making it a very good bellwether for that sector. Outside of technology, the other major sectors of the Nasdaq are Consumer Services, Healthcare, and Financials.
How Does it Work?
Similar to the S&P 500, the Nasdaq is a variation of a market weighted index. It is also the only index of the big three that is not limited to companies that have a US based headquarters.
The Nasdaq is also the only one of the big three indexes that has two different reported values – the total return index and the price return index. The price return index does not account for dividends whereas the total return index accounts for dividend reinvestments on their respective ex-dividend dates.
To be eligible for entry into the Nasdaq Composite, companies must:
- Be listed exclusively on the NASDAQ Exchange (unless the security was dual listed on another exchange prior to 2004 and has continuously maintained that dual listing)
- Securities must also be one of the following:
- American Depositary Receipts (ADRs)
- Common Stock
- Limited Partnership Interests
- Ordinary Shares
- Real Estate Investment Trusts (REITS)
- Shares of Beneficial Interests (SBIs)
- Tracking Stocks
The Nasdaq index is consistently calculated throughout the day and has a value reported by the exchange once a second during trading hours. At 4:16pm every trading day the confirmed final value is reported by the exchange.
Other Indexes to Know
There are roughly 5,000 different stock indexes in the US alone. Most are just different variations and subsets of the three that we talked about above. There are, however, two more that are worth mentioning.
- Russell 2000: The Russell 2000 is a US market index that measures the performance of the 2,000 smallest capitalized companies in the larger Russell 3000 index. The index is a market weighted index. Many investors follow this index when they are trying to compare performance relative to “small-cap” companies.
- Wilshire 5000: The Wilshire 5000 is a US oriented market index that holds roughly 3,5000 stocks (it held 5,000 when it was first released). This index is composed of entirely US companies and is frequently used as a benchmark for the entire US market.