When I meet with a prospective client for the first time, I try to explain a little about my approach to investments. On a couple of occasions when I’ve mentioned “index mutual funds,” someone has asked me, “what’s an index?” I’m always happy to get this kind of question; such questions help me remember that not everyone on the planet is a personal finance geek (and that’s a good thing).
The Earliest US Market Index
The idea of a market index, in the US at least, apparently began with Charles Dow, the founder of the venerable Wall Street Journal. He began calculating an index to measure the price changes of several transportation-related stocks and called it the Dow Jones Transportation Index. The year was 1884 and railroads dominated the transportation industry (and the US economy). Of the eleven companies in the transportation index, nine were railroads; the other two were Western Union (then a telegraph monopoly) and a steamship company.
Purpose of Market Indices
The idea was this: if you want to measure how the stock market as a whole (or a particular segment of the stock market) is doing, you need to look at the price of more than one company. Why? Because its price might be affected by a company-specific problem rather than industry- or economy-wide issues, and you want a picture of how the larger market is performing. A well-made stock market index would therefore need to include the stocks of a large enough number of stocks to be representative of the market as a whole. If the index goes up over time, the stock prices are generally rising. When this happens, the value of the companies is increasing, because the stock represents ownership in the companies. If the index goes down over time, the opposite is true.
Dow’s better-known index invention, the Dow Jones Industrial Average (“DJIA” or sometimes, “the Dow 30 Industrials”), was developed in 1896. The DJIA included twelve companies selected to represent the most important parts of the American economy. Over the years, the companies in the index and the number of companies present have changed to reflect changes in the economy. The DJIA is now based on the stock prices of 30 companies, and General Electric is the only company of the original twelve that is still used in the average.
Although the Dow Jones Industrial average continues to be calculated, most people now view it as only a rough benchmark for the stock market as a whole. The DJIA includes a handful of large companies out of thousands in the US economy, and the way the index’s value is calculated is subject to a certain amount of criticism (more on that in a bit). Many other market indices have been developed in the intervening years; each measures the ups and downs of specific areas of the stock market. Indices have also been developed for all kinds of markets, including international stocks, bonds, commodities, and probably most other asset types traded in the financial marketplaces.
Different Ways of Calculating Index Values
If you’re going to construct an index from stock prices, I suppose there are an infinite number of ways to calculate the index value. Until fairly recently, the best-known stock market indices were calculated using one of three methods, although there is now a fourth way that I’ll also discuss.
A price-weighted index begins by adding the prices of all the stocks in the index and then dividing by the number of stocks; in the simplest case it’s just the average price of the stocks in the index. This is how the DJIA was originally calculated. This is very simple, but there is a problem with it. What if a couple of stocks have much higher stock prices than the others? Those stocks would tend to have a large influence over the index value as their prices changed. If these more expensive stocks are for companies whose economic impact is actually smaller than the other stocks in the index, this would give a misleading impression of how the market as a whole is behaving.
In fact, that is one common criticism of the DJIA. When it was invented, larger companies tended to have higher stock prices, so price-weighting gave preferential weight to larger companies (or at least it did at first). Over time, stock shares experienced splits (e.g. when a company converted its existing shares into a larger number of shares and reduced the price per share of the new shares) and companies merged or went out of business and had to be replaced in the index. This meant that the calculation of the DJIA had to be adjusted to keep from having sudden, misleading discontinuities in the calculated average.
This is probably the dominant method for calculating stock indices today. In a market-weighted index, the stock price of a company that has $2 billion in stock receives twice the weight of one that has only $1 billion in stock. It reflects the fact that the first stock has a larger economic impact than the second. It seems intuitively right that a big change in the value of a large stock should cause an index to move more than a similar change in the value of a smaller one. The term used to describe the total value of a company’s stock (i.e. stock price times number of shares) is market capitalization, so these are sometimes called capitalization-weighted indices.
An argument in favor of the use of market-weighted indices is that they reflect what most or all of a particular category of stocks is doing. An index like the S&P 500 index does a reasonably good job of reflecting the overall performance of US large-capitalization stocks as a group. There is something called “modern portfolio theory” (on my list of things to explain later in this blog) that leads to the conclusion that it’s better to own the whole stock market than to try to guess ahead of time which stocks will outperform the index. For devotees of this way of thinking, market-weighted indices are ideal because they simply reflect the whole market.
An equally-weighted index gives the same weight to each stock in the index calculation without regard to the price or market capitalization of the stocks. This type of index gives smaller capitalization stocks the same footing as large-cap stocks in their ability to influence changes in the index. It’s sometimes argued that in a market-weighted index, very large companies have an exaggerated impact on the index value. For example, of the 500 stocks in the S&P 500 index, the 20 largest stocks constitute almost 30% of the index, so that big changes in a few of these stocks can have a large impact on the value of the index.
If you believed that very large companies were not going to perform well on average, it would be better to invest in an equally-weighted manner rather than according to market weight, because equal weighting would give greater emphasis to smaller companies. At this point though, we’re really crossing into the realm of investment strategies, and I really just wanted to talk here about what an index is.
- Fundamental weighting
This is the newest approach to making an index. When people talk about the “fundamentals” of a stock, they’re referring to the underlying company’s cash flow, sales, book value, and other characteristics. It is sometimes the case that stocks become overvalued or undervalued relative to these fundamental characteristics. This is what happened in the first part of this decade, when high-tech stock prices soared well beyond the underlying financial properties of their companies. If this happens, a market-weighted index becomes heavily weighted in overvalued stocks and under-weighted in undervalued stocks. Recently, it has been proposed that a better way of constructing an index is to consider not only market capitalization, but fundamental characteristics, and to weight the index accordingly. This is the most complicated of the approaches, and obviously the choice of which factors to apply and how to weight them requires making some assumptions about which properties are most important.
Other aspects of index construction
Investment experts are willing to argue until they’re blue in the face about which index-weighting method is most desirable. Since there are many financial products built around different indices, these arguments are often conducted by people who have a vested interest in the outcome of the debate, i.e. their salaries (or if they are academics, their reputations and their salaries) depend on persuading the investing public that their preferred approach is the best one.
Indices are often developed based on the size of the companies included (large-cap, mid-cap, and small-cap), the price of the companies relative to some valuation criteria (“growth” versus “value” stocks), or the geographic location of the companies in the index. Many indices follow the lead of the Dow Transportation Index and target particular segments of the economy, like biotechnology, financial services, retail, etc. Indices have been constructed using other criteria as well. There are indices constructed based on ethical criteria for the companies included, and there are even “green” or ecologically-oriented stock indices.
New indices are being invented all the time, not only because of human creativity, but also partly because financial companies want to market new mutual funds, exchange-traded funds, and other financial products that are linked to these indices (I personally refer to this phenomenon as “index bloat;” I was disappointed to learn that this already seems to be a term of art in the programming world). The proliferation of market indices will doubtless continue, as financial markets are always evolving.