Everything about Stock Market Index totally explained
A
stock market index is a method of measuring a stock market as a whole. The market can be Canadian stocks, American stocks, Bio-tech stocks, small-cap stocks, growth stocks, or any other market of interest. Many indices are compiled by news or financial services firms and are used to benchmark the performance of portfolios such as
mutual funds.
Types of indices
Stock market indexes 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 indexes are broad-base indexes comprised of the stocks of large companies listed on a nation's largest stock exchanges, such as the American
Dow Jones Industrial Average and
S&P 500 Index, the British
FTSE 100, the French
CAC 40, the German
DAX, the Japanese
Nikkei 225, the Indian
Sensex 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 U.S. stocks traded on the
New York Stock Exchange (but not
ADRs) and most traded on the
NASDAQ and
American Stock Exchange.
Russell Investment Group added to the family of indexes by launching the
Russell Global Index
.
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 indexes 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 a
Price-weighted index such as the
Dow Jones Industrial Average and the
NYSE ARCA Tech 100 Index, 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
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 for example all outstanding shares were included. Recently, many of them have changed to a
float-adjusted weighting which helps
indexing.
Critique of Capitalization-Weighting
The use of capitalization-weighted indexes is often justified by the central conclusion of modern portfolio theory that the optimal investment strategy for any investor is to hold the market portfolio, the capitalization-weighted portfolio of all assets. However, empirical tests conclude that market indexes are not efficient. This can be explained by the fact that these indexes don't include all assets or by the fact that the theory doesn't hold. The practical conclusion is that using capitalization-weighted portfolios isn't necessarily the optimal method.
As a consequence, capitalization weighting has been subject to severe criticism (see for example Haugen and Baker 1991, Amenc, Goltz, and Le Sourd 2006, or Hsu 2006), pointing out that the mechanics of capitalization weighting lead to trend-following strategies that provide an inefficient risk-return trade-off.
Also, while capitalization weighting is the standard in equity index construction, different weighting schemes exist. First, while most indexes use capitalization weighting, additional criteria are often taken into account, such as sales/revenue and net income (see the “Guide to the Dow Jones Global Titan 50 Index”, January 2006). Second, as an answer to the critiques of capitalization-weighting, equity indexes with different weighting schemes have emerged, such as "wealth"-weighted (Morris, 1996),
“fundamental”-weighted (
Arnott, Hsu and Moore 2005), “diversity”-weighted (Fernholz, Garvy, and Hannon 1998) or equal-weighted indexes.
Indexes 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 - a result nearly equal to the average expense ratio of mutual funds (fund expenses are a drag on the funds' return by exactly that ratio). 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 fund managers' 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.
Ethical stock market indices
A notable specialised index type is those for
ethical investing indexes that include only those companies satisfying ecological or social criteria, for example those of
The Calvert Group,
KLD,
FTSE4Good Index,
Dow Jones Sustainability Index and
Wilderhill Clean Energy Index.
Another important trend is strict mechanical criteria for inclusion and exclusion to prevent market manipulation, for example in Canada when
Nortel was permitted to rise to over 50% of the
TSE 300 index value. Ethical indices have a particular interest in mechanical criteria, seeking to avoid accusations of ideological bias in selection, and have pioneered techniques for inclusion and exclusion of stocks based on complex criteria. Another means of mechanical selection is
mark-to-future methods that exploit scenarios produced by multiple analysts weighted according to probability, to determine which stocks have become too risky to hold in the index of concern.
Critics of such initiatives argue that many firms satisfy mechanical "ethical criteria", for example regarding board composition or hiring practices, but fail to perform ethically with respect to shareholders, for example
Enron. Indeed, the seeming "seal of approval" of an ethical index may put investors more at ease, enabling scams. One response to these criticisms is that trust in the corporate management, index criteria, fund or index manager, and securities regulator, can never be replaced by mechanical means, so "
market transparency" and "
disclosure" are the only long-term-effective paths to fair markets.
Environmental stock market indices
An environmental stock market index aims to provide a quantitative measure of the environmental damage caused by the companies in an index. Indices of this nature face much the same criticism as Ethical indices do — that the 'score' given is partially subjective.
However, whereas 'ethical' issues (for example, does a company use a
sweatshop) are largely subjective and difficult to score, an environmental impact is often quantifiable through scientific methods. So it's broadly possible to assign a 'score' to (say) the damage caused by a tonne of
mercury dumped into a local river. It is harder to develop a scoring method that can compare different types of pollutant — for example does one hundred tonnes of
carbon dioxide emitted to the air cause more or less damage (via
climate change) than one tonne of mercury dumped in a river (and poisoning all the fish).
Generally, most environmental economists attempting to create an environmental index would attempt to quantify damage in monetary terms. So one tonne of carbon dioxide might cause $100 worth of damage, whereas one tonne of mercury might cause $50,000 (as it's highly toxic). Companies can therefore be given an 'environmental impact' score, based on the cost they impose on the environment. Quantification of damage in this nature is extremely difficult, as pollutants tend to be market
externalities and so have no easily measurable cost by definition.
Innovations Awards to Stock Indexes
- Most Innovative Benchmark Index
- Most Innovative ETF
- Most Innovative Index Derivative
- Best Index-related Research Paper
- Lifetime Achievement Award
Further Information
Get more info on 'Stock Market Index'.
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