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

A handful of equity indices have become shorthand for the performance of the world’s stock markets – the S&P 500 for the US, the FTSE 100 for the UK, the Euro Stoxx 50 for the Eurozone, the MSCI World for the developed markets. 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 (ETF, structured products, …), support research on financial markets, or a combination of these uses.

How are these influential indices calculated?

Index methodologies contain 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 capitalization, sector, and geography. Liquidity, a measure of how frequently the security is traded, is also often a key criterion of eligibility.

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

Once the stocks are selected, they are weighted (each component relative to one another) according to the criteria set by the index provider. This weighting scheme will then determine how much each individual stock contributes to the index’s overall performance. Knowing how an index is calculated is also relevant for investors that want to understand the value of the index and follow index “ticks”. The final element of the index methodology worth considering is the review process, or how the index is maintained on an ongoing basis, how is the index provider ensuring the index remain consistent with its objective, with some securities added and others dropped and share counts adjusted to reflect the actual number of shares available for trading.

For investor, another important difference is the types of returns the index will duplicate. In a price return index, the changing value of the index reflect only the change in prices of the multiple components. On the other hand, in a total return index, the changing value is determined by a combination of the price changes and reinvested income from dividends or other cash payouts. No need to be a rocket scientist to grasp that total return on an equity index in which any of the components pay dividends will always be higher than the price return, and that this difference is snowballing significantly with time.

Obviously, the world of financial market indices doesn’t stop at equity. The intended exposure could be almost any market segment that’s trackable, as for instance any other asset classes, subclass, or sector. It might focus on a single country, a combination of countries, or the global marketplace. It might identify a strategic or thematic objective (dividend income, growth, value, risk management related, …). A primary consideration in defining a universe is that there must be publicly available prices for the types of assets that the index would potentially include.

A primary consideration is that there must be publicly available prices for the types of assets that the index includes.

Different indices reflect various segments of financial markets. Different providers (S&P Dow Jones, MSCI, FTSE Russel, Bloomberg, …) create these indices using diverse methodologies. To make a long story short, this sounds like a puzzle with multiple pieces.

So, what should every investor try to understand amidst this index maze?

Obviously, investor should not stop at geographic or industry dimension. The constituent selection, weighting approach, and even rebalancing frequency can greatly influence an index’s performance and risk profile. It’s like being handed different pieces of a puzzle, each one offering a unique view of the market landscape. Just as puzzle piece might not fit if forced into the wrong place, an index might not suit an investor’s goals if its methodology doesn’t align.

Can I invest directly in an index?

In trying to grasp the essence of indices, it’s important to understand that no one, neither institutions nor individuals, can invest directly into those. An index is merely a number, a hypothetical basket, a mathematical construct tied to the underlying’s that make the specific market segment.

The only way an investor can participate in index investing is in a derivative manner, owning shares via an index mutual fund, or via an ETF, that in turn, owns the stocks dictated by the market segment. There are thousands of investment products that track indexes available through product providers and fund issuers.

Index-tracking investments (also referred to as “passively managed” products) are different from actively managed investments in that, rather than making active investment decisions to outperform a particular market or market segment, they aim to closely mimic an index by holding the same securities at the same weight as the index.

Many investors sing the praises of index funds. They cite high performance, low expenses, broad market representation, and ease of use. Sceptics praise hidden dangers of choosing the stocks by virtue of being on “the list”, without any sort of fundamental valuation disciplines. Another common critic relies on the idea that passive investing can encourage crowding into specific corners of the market, creating a liquidity risk.

What should be taken for granted is the challenge in selecting stocks, as most of them don’t move the needle. Academic research has shown most stocks don’t really matter. The typical stock may be up a bit or down a bit, while more than a few disasters crash and burn. The big drivers of equity market returns are the less than 2% of publicly traded companies that put up those giant performance numbers over an extend period of time. In bookmaker terminology, the betting odds are worse than 50 to 1 against you picking those big winners.