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A stock market index measures movements in a group of stocks, and its purpose is to measure a specific market, sector, or an industry. There are other indices as well, which measure prices of fixed income products, baskets of foreign currencies, and commodities. Many index funds as well as exchange-traded funds are based on such indices. Therefore, the indices not only measure movements in prices but also serve as portfolio allocation benchmarks.
The way price-weighted indices are measured is by assigning a value to every component (such as a stock of a company) based on its price. As a result, a stock that trades at $50 will have double the weight of a stock that trades at $25.
An example of such an index is the famous Dow Jones Industrial Average. It is composed of 30 stocks. (Note that this index occasionally replaces the stocks, so it is different than it was 20 or 30 years ago.) This index has such companies as General Electric (which traded around $15 at the time of the writing of this article) and Goldman Sachs, which traded around $267 at the same time. The difference in prices is about 18 times. Therefore, Goldman Sachs has more influence on Dow Jones 30 value than General Electric.
Speaking of Dow, there’s also Dow Transportation Average, composed of 20 companies, and Dow Utilities Average, which consists of 15 companies. Finally, Dow Jones Composite Index combines the three averages of 65 companies.
Another example of a price-weighted index is Japan’s Nikkei 225. Many investment professionals consider price-weighted indices not to be very representative of stock market movements since the price, not a market capitalization, affects it. For example, Company A trades at $10 and has a market cap of $10 billion, while Company B trades at $50 and has the same market cap. With a price-weighted index, Company B’s price movements count more 5 times than Company’s A movements even though both companies have similar market values.
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In a capitalization-weighted index, each component (stock) influences the total index based on its market cap. That’s why another name for such an index is market-value-weighted index.
For example, if the market capitalization of a total index is $100 billion, and Company A has a market cap of $10 billion, it will account for 10% of index value and its price movement. Also, if Company B has a market cap of $5 billion, it will account for 5% of the index. The stock price of each company doesn’t matter in this case. (However, the changes in price affect market capitalization.)
This type of an index is more realistic when it comes to accounting for market values. No wonder it is more popular than a price-weighted index. Popular capitalization-weighted indices include NASDAQ Composite, Britain’s FTSE-100, Germany’s DAX, France’s CAC 40, Hong Kong’s Heng Seng, and many others. Also, America’s Russell 2000 (index of small cap stocks) is based on market values rather than prices.
Another capitalization-based index is S&P 500, which is an index composed of the biggest 500 publicly-listed companies by market capitalization in the United States. (As with Dow Jones, companies are added to and dropped from the index over time.)
However, S&P 500 is adjusted for a free float, which is the percentage of shares held by the public. Therefore, it excludes closely held shares. If 90% of the shares are publicly held, then the market capitalization of a company in the index gets multiplied by 0.9 before being added to the index. By accounting for only publicly held shares that are readily available for trading, this methodology seeks to be a fairer representation of market movements.
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Another name for an equal-weighted index is unweighted index. Each component of such an index is given an equal value, regardless of its price and market value. So, if there are three stocks in the index, and one goes up by 10%, the second by 5%, and the third by 1%, then the increase in the index would be as follows:
Since prices change, while each component needs to represent an equal share, this index requires frequent rebalancing. This adds to costs for funds based on such an index. Also, between rebalancing, weights of some companies increase in value in comparison to those companies that have risen less or fallen more.
In addition to stock market indices mentioned above, there are many other indices. MSCI World Index gives different weights for countries. For example, the United States accounts for nearly 60% of the index’s value, Japan for almost 9%, UK for 6.5%, France for 4%, and Germany for slightly more than 3.5%. Also, different sectors have their own weights. Financials account for over 18%, Information Technology for over 17%, Consumer Discretionary for 12.5%, Healthcare for almost 12%, and so on.
When it comes to MSCI Emerging Markets Index, China is the biggest component with over 30% of index’s weight. South Korea comes second with nearly 15%. Next is Taiwan with slightly above 11%, then India at nearly 8.5%, and Brazil at over 7%.
As mentioned before, there are funds based on such indices such as iShares Emerging Markets Exchange-traded Fund (ETF). Some ETFs, though, modify weights in their portfolios, so they differ from original index weights.
Sector and Industry Indices
The entire economy can be broken into sectors and then sectors into industries. A very general breakdown consists of manufacturing/industrial, services, and agriculture/fishing/mining sectors. A more modern approach breaks the economic activities into 11 sectors. These include financials, industrials, energy, utilities, healthcare, technology, telecom, real estate, materials, consumer discretionary, and consumer staples.
There are specific ETFs that are based on these sectors. For example, investors seeking decent dividend yields can invest in Vanguard Utilities ETF. Or investors looking for defensive stocks (which tend to overperform the market during recessions) have multiple choices such as Consumer Staples Select Sector SPDR ETF.
Sectors get broker into industries. For example, financials can be broken into multiple industries such as banking, consumer finance, capital markets, insurance, and others. Meanwhile, healthcare sector is composed of several industries such as biotechnology, healthcare equipment, healthcare providers, healthcare technology, life sciences tools & services, and pharmaceuticals.
There are market indices for various industries. For example, NASDAQ’s Bank Index can be found under ticker “BANK.” For investors looking to invest in a specific industry, there are various ETFs and index funds.
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There are also indices that measure commodity prices. Dow Jones Commodity Index (ticker: DJCI) is a broad-based index based on futures markets. There’s a related ETF that tracks it. Its portfolio is allocated to gold, silver, oil (both WTI and crude), natural gas, copper, aluminum, corn, soybeans, and sugar.
There are more specific commodity indices that track prices of single commodities such as Brent crude, cocoa, aluminum, and coffee indices. There are also indices that track specific commodity groups such as Dow Jones Precious Metals Index, which measures performance of actual stocks of companies involved in exploring and producing gold, silver, and platinum. And there are specific ETFs that follow acquire metals including ETFS Physical Precious Metals Basket (NYSE ARCA ticker: GLTR). This fund actually buys and stores precious metals rather than buying futures contracts on them.
Other commodity groups also have their indices and ETFs or ETNs (Exchange-traded Notes). For example, there’s Elements Rogers International Commodity Index-Agriculture TR ETN (NYSE ARCA ticker: RJA). It relies on front-month futures contracts (meaning it is rebalanced monthly). It tracks Rogers International Commodity Index- Agriculture Total Return, with its segment benchmark being the S&P GSCI Agriculture. However, this particular ETN has made some adjustments by cutting benchmark’s exposure to corn and soybeans, while increasing its exposure to cotton and by adding livestock. Among its holdings are cotton, wheat, corn, soybeans (including soybean oil), coffee, live cattle, cocoa, lean hogs, and lumber. The weights differ. For instance, corn represents over 13% of the portfolio, while lumber represents less than 3%.
Fixed Income Indices
Bonds and other fixed income products have their own indices, too. One of them is S&P 500 Bond Index. An index can have a subindex. In this case, there’s S&P 500 Investment Grade Corporate Bond Index, which consists of only investment grade bonds.
There are Exchange-traded Funds based on bond indices such as iShares iBoxx $ Investment Grade Corporate Bond ETF that tracks Markit iBoxx Liquid Investment Grade Index. This ETF invests in U.S. corporate bonds with various maturities.
Moreover, there are international bond indices. For example, S&P 500 Global Developed Sovereign Bond Index tracks performance of foreign bonds denominated in their local currencies and issued in developed markets.
When it comes to emerging markets bonds, there are bond indices to track their performance and ETFs based on them. These give investors plenty of opportunities to invest and diversify.
Currencies have their indices as well. One well-known one is Bloomberg Dollar Spot Index. It tracks a basket of 10 major currencies vs. US dollar.
There are multiple currency ETFs and ETNs, which investors can buy to get exposure to currencies. For example, there’s Currency Shares Swiss Frank ETF (ticker: FXF) issued by Guggenheim. For investors interested in China, there’s Market Vectors Chinese Renminbi/USD ETN.
Multi-asset Global Index Funds
Investors can allocate their portfolios across, industries, asset classes, countries, and currencies with various ETFs and ETNs mentioned here. Portfolio allocations can be done by underweighting and overweighting specific ETFs/ETNs as well as index funds.
There are also multi-asset global funds that make portfolio allocations and diversifications simpler. Some funds invest in various countries and more than one asset class, therefore providing a decent degree of diversification.
One of such index funds is BGF Global Multi-Asset Income Fund. It seeks to create income and long-term capital growth. It invests nearly 65% in North America, 21% in Europe, and over 11% in Emerging Markets. When it comes to asset classes, it invests 17.5% in U.S. equities and over 14% on non-U.S. equities, over 42% in U.S. fixed income, and nearly 24% in non-U.S. fixed income securities.
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Nearly every investor is familiar with financial markets indices. But often this familiarity is quite shallow. Here we go into more details about these indices and investment funds based on them. To be an educated investor, you need to know them.