S&P 500, Euro Stoxx 50, FTSE 100 – what are the stock market indices?

A handful of share price indices have become shorthand for the performance of the world’s stock markets – the S&P 500 for the US, the Euro Stoxx 50 for the eurozone, the FTSE 100 for the UK, the MSCI World for developed markets worldwide. How are the world’s most influential stock market indices calculated? Is it possible to invest directly in an index?

The purpose of an equity index is to provide a measure of the performance of that market. The intended use of an index may be to benchmark portfolio performance (is my portfolio delivering better or worse return than the index?), underlie an investment product, such as an exchange-trade fund or structured product, provide inputs into research on financial markets, or a combination of these functions.

Index methodologies set out the rules that dictate how an index functions and ultimately help to determine how it performs. An equity index is created by selecting a group of stocks. The selection criteria to achieve the intended exposure vary, but typically include market capitalisation, sector choice and geography. Liquidity, a measure of how frequently and in what volume a share is traded, is also often a key criterion of eligibility for an index.

The selection criteria to achieve the intended exposure vary but typically include market capitalisation, sector choice and geography.

How are stock indices calculated, and how do they change?

Once stocks are selected, they are weighted relative to one another according to the criteria set by the index provider. This weighting system determines how much each individual company contributes to the index’s overall performance. Knowing how an index is calculated is also relevant for investors that want to understand its value.

Many indices are weighted by capitalisation, such as the S&P 500. It comprises the 500 companies with the biggest capitalisation – the number of outstanding shares multiplied by the current share place in the US. But the Dow Jones Industrial Average is weighted by share price, not companies’ total market value; and there are also equally-weighted indices, in which each constituent has the same weighting. The S&P 500 Equal Weight Index contains the same companies as the capitalisation-weighted S&P 500, but each is allocated a fixed weight – 0.2% of the index total – at each quarterly rebalancing.

The final element of the index methodology to be considered is the review process, or how the index is maintained on an ongoing basis – how the provider ensures that the index remains consistent with its objective. This will typically involve the removal of shares that have lost value and their replacement by others that have gained, and the adjustment of stock counts to reflect the actual number of shares available for trading.

For investors, another important difference is the kind of return the index will replicate. For a price return index, the changing value of the index reflects only changes in share prices of the constituent companies, but a total return index reflects a combination of price changes and theoretical reinvested income from dividends or other cash payouts. Clearly, the total return from an equity index in which any of the component stocks pay dividends will always be higher than a pure price return, and this difference expands steadily over time.

Benchmarks for every market sector

However, the world of financial market indices is not limited to equities. They can track almost any area of market segment that is measurable, such as any other asset class including bonds, sub-classes or sectors. They can focus on a single country, a region or combination of countries, or the complete global marketplace.

An index may measure a strategic or thematic objective such as dividend income, growth and value stocks, or measurement of an indicator on a risk-adjusted basis. A primary consideration in defining the universe to be measured by an index is that there must be publicly-available prices for the types of asset that it may include.

A primary consideration is that there must be publicly available prices for the types of asset that the index may include.

Different indices are designed by providers – leading market participants include S&P Dow Jones, MSCI, FTSE Russell and Bloomberg, but there are many more – to reflect various segments of financial markets, using a diverse range of methodologies. But how can investors make sense of them all?

Obviously, investors look at more than the geographic area or industry covered by an index. The constituent selection, weighting approach, and even rebalancing frequency can greatly influence an index’s performance and its risk profile. The different criteria affect the picture drawn by the index of the market landscape. An index may not meet an investor’s requirements if its methodology is not aligned with the factors critical to achievement of their goals.

Investment in an index

It is important to understand that neither institutions nor individuals can invest directly into an index, which is merely a number, a hypothetical basket of shares, bonds or other securities; a mathematical construct tied to the underlying assets that make up the particular market segment.

However, an investor can participate in index investment through a derivative product – an index-tracking investment fund, of which exchange-traded funds are by far the most common type – that owns the securities in the particular geographical markets and/or industry segments that make up that index. Thousands of index-tracking investment products are available.

Index-tracking investments, which are known as passively managed products, are different from actively-managed investments in which the portfolio manager chooses the securities in which to invest, seeking a better performance than that of the market as a whole. By contrast, passive investment products seek to replicate as far as possible the performance of an index by holding the same securities at the same weighting.

Pros and cons of index trackers

Many investors are highly enthusiastic about index funds, which have won an increasing share of institutional and individual investment over the past two decades. They cite performance that tracks the market as a whole – stock markets have risen sharply over that period – as well as broad market exposure, ease of use, and significantly lower charges than actively-managed funds, although the pressure of competition is starting to bring down costs for these products, too.

Sceptics point to hidden dangers of choosing stocks simply by virtue of their share price level, market capitalisation or other criteria, in most cases without any sort of fundamental valuation discipline. Another common criticism argues that passive investment can lead to crowding into specific corners of the market, creating liquidity risks.

Nevertheless, just as index products are now a seemingly permanent feature of the investment landscape, indices will continue to play a primordial role as benchmarks to assist oversight of market trends and investment decision-making. Understanding how they work, and what they are showing, is critical, although indices are a tool, not a substitute for individual judgement.