Stock Market Index

A stock market index is an aggregate value arrived at by combining several stocks or other investment vehicles and expressing their total values against its value as on a specified base year. It is a statistical measure of change in a specific market; an imaginary portfolio of stocks representing a particular market or a portion of it. Some indices are benchmark indices, while others are used to measure performance of different sectors or portfolios such as mutual funds.

A stock market index may alternately be considered as a tradable instrument, which derives its value from the underlying instruments or indices that it represents. An index may be a simple index that reflects the net change in the value of underlying financial instruments. However, most of the popular stock market indices are weighted and take into account market capitalization of their components along with some other factors.

Index Types

There is no set way of classifying stock market indices. A global stock market index may include large companies regardless of the stock exchange/s where they are traded. Two popular examples of such indices are MSCI World and S&P Global 100.

In contrast, a stock market index based on domestic companies represents the performance of the stock market of the country it refers to. By extension, it is a reflection of the investor sentiment on the state of the country’s economy. The British FTSE 100, American S&P 500, the Japanese Nikkei 225, the Indian SENSEX, the Brazilian Ibovespa and the Russian RTSI are among the most widely quoted national indices.

Some indices extend beyond the scope of a stock exchange. The Wilshire 5000 index, for example, is a market capitalization weighted index that reflects the market value of over 4,100 actively publicly traded stocks in the USA across stock exchanges. This includes nearly all stocks (barring ADRs and limited partnerships) traded on the New York Stock Exchange, American Stock Exchange and NASDAQ. With the launch of the Russell Global Index, the Russell Investment Group has also joined the family of companies involved in development and marketing of global indices.

Sectoral indices, on the other hand, are customized for tracking the performance of specific industries; the Morgan Stanley Biotech Index comprises of 36 biotechnology firms of USA while the Wilshire US REIT reflects the value of 80 US real estate investment trusts. Similarly, there may be more specialized indices that track companies of a certain size or a type of management. There is no end to specialization; Linux Weekly News publishes an index based on the performance of stocks of companies that sell Linux OS-based products and services.

Index Variants

A stock market index may have several versions. While the components remain the same there is a difference in how they are weighted and the method of accounting for dividends. For example, the American S&P 500 has three versions. One considers only the price of the components, while the other two consider dividend reinvestment and dividend reinvestment after the deduction of withholding tax.

The Wilshire 4500 and Wilshire 5000, on the other hand, have five versions each. Three versions are price-based: full capitalization price, float-adjusted price and equal weight. The difference being the way the components are weighted. The other two, float-adjusted total return and full capitalization total return, take into account the fact of dividends in different ways.

Price Weighted Indices

Stock market indices may be classified according to the methods used for determining their value. Indices such as the Dow Jones Industrial Average, the NYSE ACRA Tech 100 Index and Amex Major Market Index consider only the price of the components regardless of size of the company. This translates into a situation where price movement in a single component stock has a significant effect on the value of the index as the relative size of the company is ignored. On the contrary, indices such as the Hang Seng Index and India’s Nifty are market capitalization weighted indices that take into account the size of the company. This means that a relatively small change in the price of a large company has a bigger influence on the value of the index as compared to a similar movement in a small company. While market capitalization weighted indices are based on total value (number of shares multiplied by price), a market value weighted index is weighted on the basis of number of share alone.

Traditionally, weighted indices, both market capitalization and share weighted types, consider all shares of the company regardless of whether they were available for trading or not. In recent times, many indices have changed from full weighting to float-adjusted weighting that considers only as much shares as are available for trading.

A modified capitalization-weighted index is a cross between market capitalization weighting and equal weighting. It is a slightly different form of market capitalization weighted index inasmuch as that the largest stocks are capped to a percent of the weight and the excess is distributed amongst stocks under that cap in equal proportions.

In 2005, Standard & Poor’s introduced attribute weighted indices; S&P Pure Growth Style Index and S&P Pure Value Style Index. In attribute weighted index, stocks are selected and weighted on the basis of the score a particular stock gets relative to the value attribute defining the index.

Arguments against Capitalization Weighting

The modern portfolio theory states that the choice of proportions of various assets is the key to maximizing the expected returns from a portfolio or minimizing the risk for a given level of expected return. Market capitalization weighted indices are justified exactly on the basis of this conclusion. However, tests based on experiences and observations indicate that market indices are not efficient. For one, capitalization weighted indices do not include all assets and secondly, the modern portfolio theory does not hold, the reason why it is argued that creating a capitalization weighted portfolio is not necessarily the best method.

Capitalization weighting has been subjected to severe criticism because it leads to strategies based on following market trends. Another argument given against capitalization weighted indices is that besides market capitalization, most indices also consider additional criteria such as sales, revenue and net income. As a consequence of the criticism leveled against capitalization weighting, markets are seeing differently weighted schemes such as wealth, fundamental and diversity weighted and equal weighted indices.

Passive Portfolio Management

Portfolio management is increasingly trending towards index funds. Index funds are passively managed mutual funds as against actively managed funds where portfolio managers rotate investments aggressively in an effort to beat a benchmark index. Investment experts claim that as a rule index funds beat a majority of actively managed funds over the long term. According to an independent study an average actively managed fund gives 1.8% less return than the S&P 500 index. This almost equals the average expense ratio of managed funds. Index funds try to invest in the components of a benchmark index, which obviates the need to manage it, a process that involves expenses on research and cost of churning a portfolio and accompanying capital gains taxes.

Exchange Traded Funds or ETFs are also based on stock market indices. However, while the price of an index fund is declared daily, price of an ETF is constantly changing and can be shorted in a derivatives market.

Ethical Indices

Ethical indices are specialized indices that select components that meet specific social or ecological criteria. For example the FTSE4Good Index is a series of ethical investment indices having corporate social responsibility as the main criterion for inclusion. Similarly, Dow Jones Sustainability Indexes track the sustainability performance of companies listed on the Dow Jones. The Calvert Group and FTSE KLD also have stock market indices based on social and environmental factors designed to help socially conscious investors.

In 2010, the Organization of Islamic Cooperation announced an index comprising of companies that subscribe to the Islamic philosophy of ban on alcohol, tobacco and gambling. Dow Jones Islamic Market World Index is one such index that already exists.

However, the most recent and most important trend is use a strict policy of mechanical criteria for inclusion and exclusion so as to discourage and eliminate market manipulation. Mechanical criteria refer to inclusion and exclusion of stocks on the basis of complex criteria. Mechanical criteria help developers of ethical index in avoiding accusations of ideological bias while selecting components. One means of mechanical selection that has gained popularly is the mark-to-future method. This method considers probability-based scenarios presented by market analysts in determining stocks that may have become too risky for holding in the index.

Critics, however, argue that mechanical ethical criteria is used by firms mainly in the composition of the board and hiring practices but fail to adhere to ethics when it comes to watching interests of shareholders. A commonly cited example is that of Enron. It is also argued that an ethical index gets a sentimental seal of approval putting shareholders at ease, which serves as an enabling factor for scams. Another argument suggests that factors such as trust, regardless of whether it is in corporate management or index criteria or fund or index manager, cannot be replaced with mechanical criteria. In the end, fair markets can be reached only through the time tested methods of market transparency and disclosure.

Awards for Innovative Stock Indices

The William F. Sharpe Indexing Achievement Awards recognize the contributions to the indexing industry and are presented annually to different types of indexes that are most innovative and representative of the market they pertain to.

Most Innovative Benchmark Index

2004 — CBOE S&P 500 BuyWrite Index (BXM)[8]

2005 — FTSE/RAFI Fundamental Index Series

2006 — Standard and Poor’s Case-Shiller House Prices Indices

2007 – CBOE S&P 500 PutWrite Index (PUT)[9]

2011 – S&P GSCI Dynamic Roll Index

Most Innovative Index Product

2004 — CBOE Volatility Index (VIX) Futures

2005 — Options on Vanguard VIPERS at the CBOE

2006 — Chicago Board Options Exchange Options on the CBOE Volatility Index (VIX)

2007 – iPath ETNs

2009 – Thomson Reuters Realized Volatility Index

Best Index-related Research Paper

2004 — Steven Schoenfeld

2005 — Rob Arnott

2006 — Eugene F. Fama and Kenneth R. French

2007 – Benchmarking Benchmarks: Measuring Characteristic Selectivity, By Kingsley Fong, David R. Gallagher, Adrian Lee, University of New South Wales

2011 – Index Volatility in Perspective, by Joanne Hill

Most Innovative ETF

2004 — iShares MSCI EAFE (EFA) and Emerging Markets

2005 — EasyETF GSCI Commodities ETF

2006 — PowerShares DB Commodity Index Tracking Fund (DBC) and PowerShares G10 Currency Harvest Fund (DBV)

2007 – SPDR DJ Wilshire International Real Estate ETF

2011 – ProShares VIX Short-term Futures ETF (VIXY)

Lifetime Achievement Award

2004 — Tim Harbert

2005 — William Sharpe and Nathan Most

2006 — Burton G. Malkiel and Ronald J. Ryan

2007 – John C. Bogle, Paul A. Samuelson, Patricia C. Dunn, William L. Fouse and John A. Prestbo

2008 – Leo Melamed, Joanne Hill, Joe Levin, and Kelly Haughton

2009 – William J. Brodsky and Gus Sauter

2011 – Lee Kranefuss