Stock Index (An Introduction)

What is Stock Index?

A stock market index is a listing of stocks, and a statistic reflecting the composite value of its components. It is used as a tool to represent the characteristics of its component stocks, all of which bear some commonality such as trading on the same stock market exchange, belonging to the same industry, or having similar market capitalizations. Many indices compiled by news or financial services firms are used to benchmark the performance of portfolios such as mutual funds.

Types of indices

Stock market indices may be classed in many ways. A broad-base index represents the performance of a whole stock market -- and by proxy, reflects investor sentiment on the state of the economy. The most regularly quoted market indices are broad-base indices including the largest listed companies on a nation's largest stock exchange, such as the American Dow Jones Industrial Average, the NYSE and S&P 500 Index, the Japanese NIKKEI 225 and the TOPIX, the British FTSE 100, the French CAC 40, the German DAX and the Hong Kong Hang Seng Index.

The concept may be extended well beyond an exchange. The Dow Jones Wilshire 5000 Total Stock Market Index, as its name implies, represents the stocks of nearly every publicly traded company in the United States, including all stocks traded on the New York Stock Exchange and most traded on the NASDAQ and American Stock Exchange. The Europe, Australia, and Far East Index (EAFE), published by Morgan Stanley Capital International, is a listing of large companies in developed economies in the Eastern Hemisphere.

More specialised indices exist tracking the performance of specific sectors of the market. The Morgan Stanley Biotech Index, for example, consists of 36 American firms in the biotechnology industry. Other indices may track companies of a certain size, a certain type of management, or even more specialized criteria -- one index published by Linux Weekly News tracks stocks of companies that sell products and services based on the Linux operating environment.

Weighting

An index may also be classified according to the method used to determine its price. In price-weighted indexes such as the Dow Jones Industrial Average and the NIKKEI 225, the price of each component stock is the only consideration when determining the value of the index. Thus, price movement of even a single security will heavily influence the value of the index even though the dollar shift is less significant in a relatively highly valued issue, and moreover ignoring the relative size of the company as a whole. In contrast, a market-value weighted or capitalization-weighted index such as the NYSE, TOPIX or the Hang Seng Index factors in the size of the company. Thus, a relatively small shift in the price of a large company will heavily influence the value of the index. In a market-share weighted index, price is weighted relative to the number of shares, rather than their total value.

Traditionally, capitalization- or share-weighted indices all had a full weighting i.e. all outstanding shares were included. Recently, many of them have changed to a float-adjusted weighting which helps indexing.

Indices and passive investment management

There has been an accelerating trend in recent decades to create passively managed mutual funds that are based on market indices, known as index funds. Advocates claim that index funds routinely beat a large majority of actively managed mutual funds; one study claimed that over time, the average actively managed fund has returned 1.8% less than the S&P 500 index. Since index funds attempt to replicate the holdings of an index, they obviate the need for— and thus many costs of— the research entailed in active management, and have a lower "churn" rate (the turnover of securities which lose favor and are sold, with the attendant cost of commissions and capital gains taxes).

Indices are also a common basis for a related type of investment, the exchange-traded fund or ETF. Unlike an index fund, which is priced daily, an ETF is priced continuously, is optionable, and can be sold short.