All About Indexes

Whether you are engaged in index investing or using them as benchmarks to track risk and performance, indexes have something to offer every investor.

Thoughtful investors can gain significant insight on the market’s behavior by studying index values and understanding what the numerical changes in indexes might represent. To help give you the context for judging index performance, it helps to first know what goes into the numbers reported by common market indicators.

What Is An Index, Really?
An index is a select group of investments whose collective performance can be taken to represent a market as a whole, or at least a clearly-defined subset of that market. While some indexes may be recalculated once a day or less, indexes representing large, liquid and active markets (such as the U.S. stock market) are typically recalculated continuously during trading periods to reflect up-to-the-moment pricing data and to indicate the direction and magnitude of the market’s price sentiments.

Of course, major U.S. equity indexes are not simply the sums of the individual prices for the investments they represent. Rather, indexes such as the S&P 500 and Dow Jones Industrial Average are statistical models of the universes they were created to mirror. They take the latest prices and adjust them to better reflect long-term changes in financial markets, the constituent companies and the economy.

The numerical values of common indexes do not directly convey either the actual daily prices or percentage changes of their constituents, and when viewed as isolated points of data, major indexes typically provide little or no actionable significance. Rather, index values are intended to be viewed in a series so they can provide timelines that can chart relative performance from a consistent foundation. An index value today can be compared with its value days, years or even decades in the past to give a meaningful estimate of how the market might have changed over that time.

The components for each index are chosen according to the stated rules and policies of that index. Moreover, each index’s value is calculated using its own proprietary formula. As a result, even though two or more indexes may include the same company in their statistics, any particular market price change for that company is likely to have different effects on each index.

Distinguishing Among Indexes
The most commonly cited stock indexes in the United States—benchmarks such as the S&P 500, the Dow, Morgan Stanley Capital International’s EAFE and Russell Investment’s Russell 2000—are actually parts of large index families. Some indexes in those families focus on specific areas of the market, such as large, midsized or small companies. Others specialize in sectors or investing styles such as growth and value. Each index has its own unique philosophy and methodology to consider. Here are overviews of some of the key factors you can use to compare them:

• Coverage criteria. Some indexes use rigid statistical rules to select their constituents. For example, Russell Investment Group ranks all publically traded stocks by their total market value, and then assigns each company to an index based solely on its position on that list. Others use more fluid processes. For example, Standard & Poor’s analyzes and weights the relative importance of each business sector in the economy, and then selects cross-sections of companies from each sector to create stratified samples that mirror the market.
• Diversified or focused? Among the most commonly quoted market benchmarks, the S&P 500 and Russell 1000 can be considered diversified, while the Dow Jones Industrial Average is not. Rather, the Dow is composed of 30 of the largest and most venerable companies in the U.S. economy. What it might lack in market breadth, it could make up in depth—it has been calculated continuously since 1896, allowing direct performance benchmarking that stretches for more than a century.
• Sector segmentation. Many providers of diversified indexes segment their primary indexes into sector subsets. However, the definitions of “sector” vary, with different classification schemes in use. The Global Industry Classification Standard (GICS), developed jointly by Morgan Stanley Capital International and Standard & Poor’s, forms the basis for each of these firms’ index sector distinctions. The GICS is composed of 10 sectors, each including one or more industry groups drawn from the GICS list of 24 such groups. The North American Industrial Classification System (NAICS) and its ancestors, such as the Standard Industrial Classification (SIC) system, are widely used by economists, the Securities and Exchange Commission and some other index providers. This system defines more than 400 individual industries in the economy, each of which can be grouped into one of 24 different sectors. An investor looking to use indexes for a sector rotation strategy should consider the classification systems used by the indexes.
• Market capitalization and float. In the context of indexes, there are no universally applicable definitions for large-cap, mid-cap or small-cap. A company that is listed as small in one provider’s universe may be considered medium or large in another. That’s because some index providers view only market value when making their groupings, while others may adjust their categorizations to reflect variances in company age or maturity, business factors and growth rates. “Float” is another factor that leads to variation. Some index providers consider all shares equally when assessing the size of a company; others consider only the value of shares that can be publically traded, a statistic known as the free float. For example, a company with a large number of shares held by insiders who are bound by trading restrictions will have a much smaller free float than a similar-sized company with no stock subject to trading restrictions.
• Weighting is the practice of adjusting each constituent’s contribution to the index to reflect its relative size in the index. Weighting is most typically based on price per share or total company size. In price weighting, a stock whose share price is $20 will have twice the influence on the index as one whose share price is $10. In capitalization weighting, a constituent whose total market value is twice as great as another would have twice the influence on the index. The DJIA, for example, uses price-weighting factors in its calculations, while the S&P 500 uses capitalization-weighting factors.
• Company domicile. Major stock indexes in the United States all reflect pricing action on U.S. stock exchanges. But some indexes, such as the S&P 500, include companies based outside the United States who list their shares here, while others, such as the Dow and Russell, limit their constituent universes to U.S.-domiciled firms.
• Index turnover. Some firms follow fixed schedules for reevaluating their constituent lists and making changes to those lists. Russell, for example, undertakes this kind of index revision once each year, at the end of June. Others respond more fluidly. Standard & Poor’s analysts continually monitor their index constituents and make changes as conditions warrant, sometimes daily or weekly.
• Investability and tracking error. While it may be impossible to invest directly in any index, asset managers can create portfolios that are intended to replicate index performance. Along the same lines, index architects can design benchmarks that simplify the process of replication for portfolio managers. One important tool for measuring how well a portfolio tracks an index is tracking error. In its simplest statistical form, tracking error is the arithmetic difference between portfolio returns and benchmark returns; the smaller the difference, the closer the manager is to the benchmark.

A Brief Guide to Benchmarks Around The World
The following is a list of many of the investment world’s most prominent and widely followed benchmarks. (Keep in mind that this is only a sampling; index compilers typically create broad families of benchmarks based on their overall indexing philosophies and practices.)

• Standard & Poor’s Composite Index of 500 Stocks. The S&P 500 is a broad-based index of the average performance of 500 widely-held U.S. stocks. Many believe that the S&P 500 includes the 500 largest stocks on the New York Stock Exchange—not true. Rather, it includes the stocks of companies that are or have been leaders in their respective industries and that are listed on the New York Stock Exchange and the NASDAQ system.
• Dow Jones Industrial Average (DJIA). Following the returns of 30 well-established, blue-chip U.S. companies, the DJIA is among the most renowned of the stock market indexes. However, the S&P 500 can be considered a more diversified indicator of the stock market.
• NASDAQ Composite. This index was created in 1971 and tracks all domestic and non-U.S.-based common stocks listed on the National Association of Securities Dealers Automatic Quotation System (NASDAQ) market. It is composed of more than 4,800 stocks traded via this system. Traditionally, the NASDAQ composite has been considered representative of technology stocks; today, it is composed of an ever-broadening variety of issues.
• MSCI EAFE Index. Morgan Stanley Capital International's Europe, Australasia, Far East Index is the most prominent of the indexes that track international stock markets. It is a subset of MSCI’s All Country World Index of investable markets, which reflects the performance of more than 9,000 securities across all capitalization, sector and style segments in 45 developed and emerging markets.
• Russell 1000 Index. This index measures the performance of the largest publically traded companies in the U.S. equity market. It is composed of the 1,000 largest firms as determined by Russell Investment’s annual ranking by market capitalization.
• Russell 2000 Index. The Russell 2000 Index measures the performance of the small-cap segment of the U.S. equity market. It includes the 2,000 companies ranked below the Russell 1000 in Russell Investment’s annual market-capitalization ranking.
• FTSE 100 Index. This index is part of the FTSE UK Series and is designed to measure the performance of the 100 largest companies traded on the London Stock Exchange that pass screening for size and liquidity.
• Nikkei 225 Index. This index is composed of the 225 largest stocks on the Tokyo Stock Exchange.
• Barclays Capital U.S. Aggregate Bond Index. Covering the principal investment-grade sectors of the U.S. bond market, such as corporate, government and mortgage-backed, this is among the most broadly diversified indexes of bond market total returns.
• 10-Year U.S. Treasury Bond. The yield on this long-term U.S. government bond is often looked to as the foundation bond yield for analyzing the performance potential of other long-term bond investments. The yield is not an index but a statistic derived from the reported prices for bond trades.
• iMoneyNet Money Fund Averages. These benchmarks track the averages of taxable and tax-free money market fund yields on a seven- and 30-day basis. They are not indexes but averages of reported yields as calculated by the publisher, iMoneyNet.

Investment indexes are complex devices that can be invaluable tools when used properly, and hazardous when used inappropriately. And while you cannot invest directly in any index, you can find investments that mirror the performance of a specified index. Many investors find these investments ideal for certain purposes. Contact your financial advisor for a better understanding of indexes or to find suitable index-based investments appropriate to your particular needs. iBi

Cathy S Butler, CFP, CRPC is a financial advisor at The Butler/Luthy Group of Morgan Stanley, located at 401 Main Street, Suite 1000 in Peoria. She can be reached at (309) 671-2873. To learn more, visit morganstanleyfa.com/thebutlerluthygroup.