Investing: what is an index?
An index, such as the FTSE 100 or Dow Jones, is a selection of financial assets structured to track the price performance of a specific segment of the stock market. Read on to find out more about how indices work, what they are used for, and how you can invest in them.
When people talk about the stock market rising or falling, they are normally referring to stock market indices.
An index tracks a selection of financial assets and moves up or down in accordance with the price changes of its components.
Yet, despite their prominence when discussing the markets, you can’t buy or sell indices themselves. They are purely a performance indicator and a sign of stock market health.
The only way to ‘invest’ in indices is to put your money to work in something called an index fund.
What is an index?
An index is made up of a number of different financial instruments or assets. It is designed to reflect the overall price performance of a segment of the financial market. This could be stocks, but also commodities (such as oil or gold), forex, bonds and more.
Even though indices capture the price performance of certain assets, they do not technically have any physical value themselves. You measure an index in points and refer to its point movement when discussing its gains or losses.
For example, you talk about the FTSE 100 gaining or losing a certain number of points in a day.
» MORE: How to invest in gold?
How are indices used?
Due to the make-up of indices and the fact that there are often hundreds or even thousands of underlying components, they can gain or lose points on the back of a range of factors.
These can include major geopolitical events, sector-specific headlines or wider economic data. As such, some of the indices can be seen to be a commentary on the health of the economy as a whole.
An index can also act as a benchmark with which to compare your own investment portfolio.
Ideally, you would want your portfolio to surpass the returns of indices, such as the FTSE 100 or Dow Jones. However, it can be difficult to ‘beat the market’.
Say the FTSE 100 or the Dow Jones rises by a certain amount in a year, and that percentage gain is greater than your own portfolio. This may cause you to rejig the make-up of your portfolio and look for areas of growth in those indices that are lacking in your own investments.
The same is true if you have a managed brokerage account. Your investment manager may look at the returns on the major indices compared to your portfolio and make adjustments accordingly.
How are indices weighted?
Not every component of an index is given equal weighting. Some components will have a greater influence on an index’s movements than others. How an index is weighted is determined by what the index is trying to measure.
Most commonly these days, stock market indices are weighted by free, float-adjusted market cap. This is a company’s market capitalization, but calculated only using shares that are freely available to trade, and not those held by institutions or governments. The bigger a stock’s market cap, the bigger its weighting, and therefore the greater the impact its movements will have on an index.
» MORE: What is market cap?
Other types of weighting criteria include share price or revenue.
Unweighted indices also exist. This means each component of the index is given equal weighting.
Types of index
A stock market index captures the performance of a selection of stocks. For example, the FTSE 100 Index reflects the overall share price performance of the 100 largest companies by market cap on the London Stock Exchange.
A forex index is a basket of currency pairings. The US Dollar Index allows investors to trace the strength of the United States dollar against a selection of other major currencies, such as the euro and pound sterling.
» MORE: What is forex trading?
Similarly, a commodity index is made up of a chosen selection of tradable goods. For example, the S&P GSCI is a production-weighted index, built to represent the global commodity market, and includes over 20 components, such as various precious metals, energy, and livestock commodities.
Examples of stock indices
Stock indices usually come in three forms: global, regional and national. However, they are not limited to these groupings. Other formats exist such as a thematic stock index.
Global stock market indices
The purpose of a global stock market index is to give a broad snapshot of the price performance of companies from around the world. Examples of global stock indices include:
- MSCI World Index – includes 1,559 large and mid-cap companies from 23 ‘developed market’ countries.
- S&P Global 1200 – a composite of 1,200 companies from seven headline indices from around the world, capturing 70% of global market capitalization.
- The Global Dow – measures the ‘150 leading companies’ from around the world, as selected by the senior editors of The Wall Street Journal. It is an equal-weighted index.
Regional stock market indices
Like global stock indices, regional stock indices are made up of components from more than one country or stock exchange but are focused on one region or continent. They include:
- S&P Asia 50 – made up of 50 of the largest companies from Hong Kong, China, South Korea, Singapore and Taiwan. It is part of the S&P Global 1200.
- STOXX Europe 600 – includes large-, mid- and small-cap companies from 17 European countries, and is a subset of the STOXX Global 1800 Index.
- EURO STOXX 50 – includes some of the biggest and most recognisable companies in the Eurozone specifically, such as Adidas, Philips and Volkswagen.
National stock market indices
The best known stock market indices operate on a national level and tend to reflect segments of specific stock exchanges. They include:
- FTSE 100 Index – made up of the 100 largest companies by market cap listed on the London Stock Exchange.
- Dow Jones Industrial Average – composed of 30 stocks from the New York Stock Exchange and NASDAQ, as selected by the senior editors of The Wall Street Journal. It is a price-weighted index, meaning the greater a company’s share price, the bigger its influence.
- S&P 500 – composed of 500 large-cap US companies, and seen as one of the most important indicators of the state of the US stock market.
- DAX 30 – tracks the performance of the largest 30 companies listed on the Frankfurt Stock Exchange.
- Nikkei 225 – contains 225 of the largest stocks listed on the Tokyo Stock Exchange. Like the Dow Jones, it is a price-weighted index.
Investing in indices
Since they are mainly performance indicators, and lack a physical value themselves, you can’t buy or sell an index directly.
If you wanted to, you could try to replicate an index yourself by buying shares in each of the components of the index in question. However, this could prove costly.
Fortunately, investment products exist that do exactly that for you. Index funds mirror an index by containing shares in each company that makes up an index, in the same weighting as on the index.
There are two main forms of index fund: index mutual funds and ETFs (exchange-traded funds). Both can be bought through your brokerage account.
WARNING: We cannot tell you if any form of investing is right for you. Depending on your choice of investment your capital can be at risk and you may get back less than originally paid in.
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Connor is a writer and spokesperson for NerdWallet. Previously at Spreadex, his market commentary has been quoted in the likes of the BBC, The Guardian, Evening Standard, Reuters and The Independent. Read more