A financial index produces a numeric score based on inputs such as a variety of asset prices. It can be used to track the performance of a group of assets in a standardized way. Indexes typically measure the performance of a basket of securities intended to replicate a certain area of the market.
These could be constructed as a broad-based index that captures the entire market, such as the Standard & Poor’s 500 Index or Dow Jones Industrial Average (DJIA), or more specialized indexes that track a particular industry or segment, such as the Russell 2000 Index, which tracks only small-cap stocks.
Key Takeaways
- Standardized Performance Metric: An index measures the price performance of a basket of securities using a standardized metric and methodology.
- Benchmark for Evaluation: Indexes in financial markets are often used as benchmarks to evaluate an investment’s performance against.
- Key U.S. Indexes: Some of the most important indexes in the U.S. markets are the S&P 500 and the Dow Jones Industrial Average.
- Popularity of Passive Index Investing: Passive index investing has become a popular low-cost way to replicate the returns of popular indices such as the S&P 500 Index or Dow Jones Industrial Average.
- Benchmarking Strategies: Benchmarking your investment strategy against the appropriate index is key to understanding a portfolio’s performance.
The Purpose and Benefits of Indexes
Indexes are also created to measure other financial or economic data such as interest rates, inflation, or manufacturing output. Indexes often serve as benchmarks against which to evaluate the performance of a portfolio’s returns. One popular investment strategy, known as ‘indexing,’ is to try to replicate such an index in a passive manner rather than trying to outperform it.
Indexes in finance are typically used to track a statistical measure of change in various security prices. In finance, it typically refers to a statistical measure of change in a securities market. The S&P 500 Index and the Bloomberg US Aggregate Bond Index are common benchmarks for the U.S. stock and bond markets, respectively.
Each index related to the stock and bond markets has its own calculation methodology. In most cases, the relative change of an index is more important than the actual numeric value representing the index. For example, if the FTSE 100 Index is at 6,670.40, that number tells investors the index is nearly seven times its base level of 1,000. However, to assess how the index has changed from the previous day, investors must look at the amount the index has fallen, often expressed as a percentage.
The Rise of Index Investing
Indexes are also often used as benchmarks against which to measure the performance of mutual funds and exchange-traded funds (ETFs). For instance, many mutual funds compare their returns to the return in the S&P 500 Index to give investors a sense of how much more or less the managers are earning on their money than they would make in an index fund.
‘Indexing’ is a form of passive fund management. Instead of a fund portfolio manager actively stock picking and market timing—that is, choosing securities to invest in and strategizing when to buy and sell them—the fund manager builds a portfolio wherein the holdings mirror the securities of a particular index. The idea is that by mimicking the profile of the index—the stock market as a whole, or a broad segment of it— the fund will match its performance as well.
Since you cannot invest directly in an index, index funds are created to track their performance. These funds incorporate securities that closely mimic those found in an index, thereby allowing an investor to bet on its performance, for a fee. An example of a popular index fund is the Vanguard S&P 500 ETF (VOO), which closely mirrors the S&P 500 Index.
Notable Examples of Indexes
The S&P 500 Index is one of the world’s best-known market proxy indexes and one of the most commonly used benchmarks for the stock market. It includes 80% of the total stocks traded in the United States. Conversely, the Dow Jones Industrial Average is also well known, but represents stock values from just 30 of the nation’s publicly traded companies. Other prominent indexes include the Nasdaq 100 Index, Wilshire 5000 Total Market Index, MSCI EAFE Index, and the Bloomberg US Aggregate Bond Index.
Like mutual funds, indexed annuities are tied to a trading index. However, rather than the fund sponsor trying to put together an investment portfolio likely to closely mimic the index in question, these securities feature a rate of return that follows a particular index but typically have caps on the returns they provide. For example, if an investor buys an annuity indexed to the Dow Jones and it has a cap of 10%, its rate of return will be between 0 and 10%, depending on the annual changes to that index. Indexed annuities allow investors to buy securities that grow along with broad market segments or the total market.
Adjustable-rate mortgages feature interest rates that adjust over the life of the loan. The adjustable interest rate is determined by adding a margin to an index. For instance, if a mortgage indexed to the LIBOR has a 2% margin and the LIBOR is 3%, the interest rate on the loan is 5%.
Building and Constructing a Financial Index
Indexes can be built in a number of ways, often with consideration for how to weight the various components of the index. The three main ways include:
- Market-cap or Capitalization-weighted Index: Puts more weight in the index to those components that have the largest market capitalization (market value), such as the S&P 500.
- Price-weighted Index: Puts more weight to those components with the highest prices, such as the Dow Jones Industrial Average.
- Equal-weighted Index: Allocates each component with the same weights (this is sometimes called an unweighted index).
The Utility and Significance of Indexes
Indexes are useful for providing valid benchmarks against which to measure investment performance for a given strategy or portfolio. By understanding how a strategy does relative to a benchmark, one can understand its true performance.
Indexes also provide investors with a simplified snapshot of a large market sector, without having to examine every single asset in that index. For instance, it would be impractical for an ordinary investor to study hundreds of different stock prices to understand the changing fortunes of different technology companies. A sector-specific index can show the average trend for the sector.
Major Stock and Bond Indexes
In the United States, the three leading stock indexes are the Dow Jones Industrial Average, the S&P 500, the Nasdaq Composite, and the Russell 2000. For international markets, the Financial Times Stock Exchange 100 (FTSE 100) Index and the Nikkei 225 Index are popular proxies for the British and Japanese stock markets, respectively. Most countries with stock exchanges publish at least one index for their major stocks.
While stock market indexes may most often come to mind, indexes are also constructed around other asset classes. In the bond market, for example, the Bloomberg Aggregate Bond Index tracks the investment grade bond market, while the Emerging Market Bond Index looks at government bonds of emerging market economies.
The Bottom Line
Market indexes provide a broad representation of how markets are performing. These indexes serve as benchmarks to gauge the movement and performance of market segments. Investors also use indexes as a basis for portfolio or passive index investing. In the U.S., such representative indexes include the large-cap S&P 500 and the technology-heavy Nasdaq 100.
Related Terms: S&P 500, Dow Jones Industrial Average, NASDAQ Composite, Russell 2000, passive investing.
References
- S&P Dow Jones Indices. “S&P 500”.
- Bloomberg Barclays Indices. “US Aggregate Index”, Page 1.
- FTSE Russell. “FTSE 100 Index”, Pages 1-2.
- Vanguard. “Vanguard S&P 500 ETF (VOO)”.
- S&P Dow Jones Indices. “Dow Jones Industrial Average”.
- Nasdaq. “NASDAQ 100”, Page 1.
- Wilshire. “Wilshire 5000 Total Market Index”.
- MSCI. “MSCI EAFE Index”, Page 1.
- S&P Dow Jones Indices. “SPIVA Report Card”.
