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Posted: August 30, 2013

All about the index

What is it, really?

Michael Caplan

(Editor's note: This is the first of two parts.)

Whether you are using market indexes as benchmarks to track the potential performance and risk of a given investment or you are engaged in index investing, 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 US 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 US 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 time lines 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 Different Indexes

The most commonly cited stock indexes in the United States—benchmarks such as the S&P 500, the Dow, the 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 you should 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 substantially all publically traded stocks by their total market value, and then assigns each company on that list 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. It 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, it is composed of 30 of the largest and most venerable companies in the US economy. What the Dow 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.

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Michael Caplan is a Financial Advisor and Associate Vice President with the Global Wealth Management Division of Morgan Stanley in Denver.  He can be reached at Michael.Caplan@morganstanley.com or (303) 595-2094.

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