Invest in market indexes: What they are and how they work

written on September 24, 2021

A quick glance at the financial news will surely have popular indexes like the Dow Jones, S&P 500 or Nikkei 225 mentioned. Often evoking the impression that they represent the pulse of the market, do you truly know what they are and what purpose they serve?

Market indexes are a group of stocks or other asset classes that track a slice of the financial market, be it a specific industry, region, exchange or the global market as a whole. For instance, the Nasdaq Composite Index has an abundance of technology stocks, so by looking at the index’s performance, we could gain insight as to the tech sector’s overall health. In this manner, investors can track securities easily just as they would track a single stock, enabling them to compare current and past price levels to calculate market performance.

At times, indexes can also provide a quick snapshot of the overall stock market’s financial health and even that of the wider economy.

How are market indexes compiled?

Indexes are formed by selecting a group of companies whose shares are listed on a public stock exchange and while indexes may have hundreds, if not thousands of stocks, not all are included equally. Shares are allocated via what is known as index-weighting, which takes place one of the following three ways:

  • Market capitalisation-weighted - one of the most common weighting strategies, as its name implies, market cap-weighted indexes such as the S&P 500 give more weight to larger companies with higher market cap. This is why Apple’s weighing in the S&P 500 is 7.1%.
  • Price-weighted – this gives weight to stocks with the highest share price. So in the Dow Jones Industrial Index, UnitedHealth Group (UNH) with a price of over $400 per share is weighted more than Cisco Systems (CSCO) whose stock is priced at around $55.
  • Equal-weighted – these types of indexes weigh each stock at the same level, regardless of stock price.

Companies join or are dropped from an index depending on whether their market cap increases or falls, with companies reviewed periodically to make sure that they qualify and can carry on being listed.

How do indexes go up and down?

At the very basic level, the overall performance of individual stocks will affect the index. As expected, stocks with a higher weighting have a greater influence as to how the index moves, however, many other factors like political events or trade and economic performance announcements can also impact market indexes. So if an index is mostly based on U.S. stocks, then economic data on the country’s economy, such as unemployment rates, inflation, treasury yields and so on, will affect its price.

Is there a difference between a stock index and the stock exchange?

Novice investors often believe that a stock index and a stock exchange are the same thing, using the two terms interchangeably. Yet, there are differences between the two. For instance, some stock indexes track a specific stock exchange but stocks exchanges do not track indexes. The Nasdaq is a stock exchange with a physical presence in New York City, where traders and other individuals can visit in person. The stocks traded on the Nasdaq exchange can be indexed, like the Nasdaq Composite Index, which includes almost all the stocks listed on the Nasdaq exchange, whereas the Nasdaq-100 Index, is an even more specific index that tracks the 100 largest non-financial companies traded on the exchange.

The below table outlines some of the main differences between the two.

Stock index  Stock exchange 
A collection of securities that replicate a sector or an industry. An organisation with a physical location, such as a building, where a collection of securities can be traded. 
Can be bought and sold Is defined by the stocks traded at the exchange 
Can track a stock exchange  Can be visited in person 

What are the major stock market indexes?

According to the Index Industry Association (IIA), there are more than three million stock and bond market indexes, while the U.S. alone has thousands of them. Whereas some are well-known and closely followed, others are more popular among financial professionals rather than the general public.

Here is a brief overview of just some of the most popular market indexes across the globe.

Standard & Poor’s 500 Index

Established in 1957 and more commonly referred to as the S&P 500 or simply, the S&P, this is a market capitalisation-weighted index of the 500 largest U.S. publicly traded companies. It measures the stock prices of these companies and adjusts companies’ market caps by the number of shares available to the public for trading. So if a company has 2 million shares held by shareholders and the current stock price is $5, then the company’s market cap is that of $10 million.

Apart from their market cap, to be included in the S&P 500 companies must also be based in the U.S., be listed on an eligible U.S. exchange, be structured as a corporation and offer common stock, as well as have positive earnings. Some of the companies that make up the S&P 500 include Apple (AAPL), Microsoft (MSFT), Amazon (AMZN), Facebook (FB), Tesla (TSLA) and others.

All companies combined account for about 80% of all the publicly-traded stock in the U.S. and seeing that it represents the largest publicly traded companies, the S&P is one of the most widely quoted American indexes, often viewed as a measure of how well the stock market is performing overall.

Dow Jones Industrial Average (DJIA)

Also known as the Dow 30, the Dow Jones Industrial Average is a stock market index that tracks 30 large and publicly-owned blue-chip companies that trade on the New York Stock Exchange and the Nasdaq. This means that the companies that make up the index have consistent stable earnings, some of which include Disney (DIS), Boeing (BA), Coca-Cola (KO), Walmart (WMT) and others. Unlike the S&P 500, the DIJA is a price-weighted index, which means that companies with higher stock prices have greater weight in the index’s calculation, while it takes into account historic stock splits, dividends and other changes.

The second-oldest index in the U.S. after the Dow Jones Transportation Average, the DIJA was created by Charles Dow and his business associate Edward Jones back in 1896 so that it could serve as a representation of the U.S. broader economy’s health. Despite its name, today, several of the companies that make up the index operate in sectors other than heavy industry.

The Nasdaq Composite Index

The Nasdaq Composite Index is a large market cap-weighted index of more than 2,500 stocks, established in 1971. Primarily focused on the technology sector which accounts for nearly 50% of the index’s composition, other stocks included are financial, industrial, insurance and transportation-related companies, while other types of securities the index has are American depositary receipts, real estate investment trusts (REITs), as well as limited partnership interests. Although all companies in the index are traded on the Nasdaq stock exchange, not all are based in the U.S.

Some of the companies that form part of the index include Cisco Systems (CSCO), Pepsico (PEP) and Intel (INTC), amongst others. Together with the S&P 500 and the Dow Jones Industrial Average, the Nasdaq Composite index is one of the three most followed stock market indexes.

FTSE 100 index

The Financial Times Stock Exchange 100 index, often called the Footsie, is a share index composed of 100 companies listed on the London Stock Exchange (LSE) with the highest market capitalisation. A number of analysts, traders and investors often look at the FTSE 100 to get a general idea of the wider UK stock market’s performance, just like investors and other financial professionals look to the Dow and S&P to gauge what’s going on with the U.S. economy.

The index’s level is calculated using the total market capitalisation of the companies that form part of it and the index value. The total market capitalisation is affected by the individual share prices of companies and seeing that these change throughout the day, so does the index value.

Although some of the companies in the index have homes outside of the country, most are major UK companies often impacted by daily developments in the country. Some of the index’s top holdings by market cap include Royal Dutch Shell (RDSA) Unilever (ULVR), AstraZeneca (AZN), BP Plc (BP) and others.

DAX Performance Index

Created in 1988, the DAX or Deutscher Aktien Index, in other words, the German Stock Index, represents 30 of the largest and most liquid German companies that trade on the Frankfurt Exchange, representing approximately 75% of the aggregate market cap that trades on the exchange. Some of the blue-chip companies that make up the index include Adidas (ADS), BMW (BMW), Bayer (BAYN) and Volkswagen (VOW).

DAX measures the performance of these companies in terms of order book volume and market capitalisation. The prices used to calculate the DAX index come through Xetra, an electronic trading system, while a free-float methodology is used to calculate the index weightings along with a measure of the average trading volume. By using this methodology, a company’s market capitalisation is calculated by taking the stock price and multiplying it by the number of shares available for trading.

A prominent benchmark for German and European stocks, in November 2020, it was announced that the DAX would expand from 30 to 40 members, with this expansion expected to take place sometime within the third quarter of 2021.

Nikkei 225

One of the leading and most respected indexes of Japanese stocks, the Nikkei is short for the Nikkei 225 Stock Average, which as its name implies, consists of the country's top 225 blue-chip stocks operating in a variety of industry sectors, ranging from automotive and retail to chemicals, electrical power and more. The index has been calculated on a daily basis since 1950 by the Nihon Keizai Shimbun, otherwise referred to as The Nikkei newspaper and it is a price-weighted index, so the index itself is an average of the share prices of all the companies listed. Some companies included are Toyota Motor Corporation (TM), Nissan Motor Company (7201), Canon Inc (CAJ) and Sony Corporation (SNE) to name a few.

Established as part of the country’s rebuilding and industrialisation following World War II, the Nikkei 225 is the oldest stock index in Asia.

Essentially doing the heavy lifting for investors who want to learn about how an industry, sector or the economy is performing, market indexes simplify the research process for you, while they make investing in many companies much easier as opposed to buying several different stocks. And although you can’t invest directly into any particular index, you can invest in an index ETF (Exchange-Traded Funds) that seeks to replicate and track a benchmark index.

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The contents of this article are not intended to be taken as a personal recommendation to invest but strictly based on research and for information purposes only. Retail investors should contact their financial adviser for a suitability assessment prior to taking any investment decisions.

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