It is essential to track the returns on your investment to know if you are getting sufficient returns. But how exactly do you track the performance of equity or any other asset? The answer is a financial index.
A financial index also known as a stock market index tracks the performance of a preselected group of investments, like stocks and equities. Tracking the performance of a financial index allows the investor to determine the health of the stock market, gauge the performance of their investments, and guide financial firms in the creation of exchange-traded funds(ETFs) and index funds.
In the trading space, an index is a standardized method to track the performance of your investments, stocks, equities, and other assets. Financial indexes typically measure the performance of a group of securities intended to replicate a certain market area.
In this blog, we will discuss what an index is, its examples, and how you can invest in index funds. Keep reading to learn more.
What is a Financial Index?
A financial index is used to track the performance of a group of preselected investments, like stocks, bonds, or equities. These investments often revolve around a particular industry like tech stocks, or even the overall stock market, as is the case with the S&P 500, NASDAQ, and Dow Jones Industrial Average.
A financial index produces a numerical based on inputs such as a variety of asset prices. These indexes can also be classified as broad-based indexes, capturing the entire stock market. There are also specialized indexes that track a particular industry or sector like the Russell 2000 Index, which only tracks small-cap stocks.
Moreover, there is no set size when it comes to market indexes. While the DJIA contains just 30 stocks, the CRISP index has more than 3,700. The important thing is that each index contains a large enough sample size that accurately represents the overall behaviour of the economy they aim to represent.
The Standard & Poor’s 500 Index and Dow Jones Industrial Average are two of the most popular and important indexes in the U.S. market.
How Are Indexes Used?
Besides tracking and evaluating the performance of stocks and equities, indexes are also used to measure other financial and economic data like inflation, interest rates, or manufacturing output. They also serve as a benchmark to evaluate the performance of a portfolio’s returns.
Indexing is a rather popular investment strategy in which an investor tries to replicate an index passively instead of trying to outperform it.
Finance indexes are typically used to track a statistical measure or change in the price of a security. It refers to the statistical measure of a change in a securities market. Stock and bond indexes consist of a hypothetical portfolio of securities representing a particular market or sector in financial markets.
In the case of mortgages, it refers to a benchmark interest rate created by a third party.
In the United States, the Standard & Poor’s 500 Index and Bloomberg US Aggregate Bond Index are the primary benchmarks for the U.S. stock and bond markets respectively.
Each index related to stocks and bonds has its circulation methodology. In most cases, the relative change of an index is more crucial than the actual numeric value representing the index.
For example- if the S&P 500 Index is at 6,567.04, it tells investors that the index is nearly 7 times its base level of 1,000. But, to evaluate how the index has changed from the previous day, investors must look at the amount the index has fallen, which is often represented as a percentage.
How Are Stock Market Indexes Constructed?
Each stock market index(also known as a financial index) uses its formula to choose which companies or investments to include. Indexes that measure the performance of a broad spectrum of the market may only include companies that rank highly in terms of market capitalization, or the total value of their outstanding shares. However, they may also be selected by a committee of experts and may only represent all of the shares that trade on the particular stock exchange.
Once the index manager has determined which companies to include, they also need to determine how those companies will be represented in the index, which is called index weighting. Depending on the weighting, all companies included in an index can have equal or different impact on index performance, based on share value or market capitalization.
The three most popular index weighting models are-
Market-cap Weighted: In a market cap-weighted index, the index heavily represents stocks with higher market caps. In this case, large companies with a hold on the market have a bigger impact on the index’s performance.
Equal Weighted: In an equal-weighted index, the index treats all companies equally. This means that each company’s performance affects the index equally, despite being incredibly large or mere startups.
Price Weighted: A price-weighted index grants each company a different weight based on their share price. Companies with larger share prices have more influence in these indexes, regardless of how big or small they are.
Major Stock Market Indexes for Index Funds
While there are thousands of indexes in the financial world, we have listed some of the common ones that you will probably encounter if you are an active investor.
The Standard & Poor’s 500 Index(S&P 500)
The S7P 500 index requires no introduction as it is one of the most popular financial indexes in the United States. It tracks the performance of the top 500 companies in the U.S., as determined by the S&P Dow Jones Indices committee. The S&P 500 is a market capitalization-weighted index.
The Dow Jones Industrial Average
Also known as the DJIA, the Dow Jones index tracks the performance of only 30 U.S. companies, selected by the Dow Jones Indices. It has a relatively narrow scope and the stocks within DJIA come from a wide range of industries like healthcare, technology, etc. but are united by being blue chip stocks. It means they have a history of solid financial performance. The DJIA is one of the few price-weighted financial indexes.
The NASDAQ 100
As the name suggests, the NASDAQ 100 tracks the performance of the 100 most actively traded stocks and largest companies on the NASDAQ stock exchange. There are a wide range of companies in the NASDAQ exchange, with a special focus on the technology field and no companies from the financial sector. It is a market cap weighting index.
The NYSE Composite Index
The NYSE Composite Index is an all-inclusive index that tracks the performance of every stock traded on the New York Stock Exchange(NYSE). It is a modified market capitalization-weighted index.
The Russell 2000 Index
While other stock market indexes usually focus on the largest companies in the market, the Russell 2000 index measures the performance of the 2000 smallest publicly traded domestic companies. It is a market capitalization-weighted index.
The Wilshire 5000 Total Market Index
Unlike other financial indexes that focus on specific companies based on their market share or industries, the Wilshire 5000 total market index tracks the performance of the entire stock market of the United States of America. It is a market capitalization-weighted index.
Bloomberg Barclays U.S. Aggregate Bond Index
Instead of the stock market, the Bloomberg Aggregate Bond Index is a comprehensive index that tracks the U.S. bond market. The index measures the investment grade, U.S. dollar-denominated, fixed-rate taxable bond market.
Different Types of Market Indexes
While the indexes listed above mostly represent the overall stock market, many more indexes are tailored to represent specific segments of the market.
Environmental, Social, and Governance(ESG): As the name suggests, the ESG index primarily focuses on companies that measure how well they treat the environment, their employees, management, and typically society as a whole.
Currency Indexes: The U.S. dollar index is a currency index that measures the performance of the U.S dollar concerning other leading global currencies.
Global Indexes: Global indexes track the collective performance of companies from all across the globe.
National Indexes: Just like how the stock market indexes are native to the United States of America, some indexes track the performance of companies in almost every country.
Growth Indexes: Growth indexes primarily focus on tracking the performance of leading growth stocks or the stocks of companies that are targeting faster growth than the overall market.
Value Indexes: Value indexes group together companies that are thought of as undervalued by investors based on their finances.
Sector Indexes: As the name implies, sector indexes focus on companies of a particular sector, like technology, healthcare, transportation, energy resources, etc.
Investing in Index Funds
Individual stocks and mutual funds often attempt to beat the market, that is try to perform better than their benchmark indexes. However, this practice isn’t reliable and often fails. Instead, investors are using passive investing strategies like ETFs or index funds that aim to mirror broad-market or a particular sector’s performance, instead of trying to beat it.
Index funds and ETFs are funds that are representative of an entire index, like the S&P 500, so that the performance rises and falls alongside the benchmark index. As index values rise over time, index funds and ETFs are a great way to build long-term wealth.
Indexing is a passive form of fund management. Instead of handpicking the securities and strategizing when to buy or sell them, the fund manager builds a portfolio where the funds mirror the securities of a particular index. The strategy is to mirror the profile of the index, the stock market as a whole, or a specific segment of it so that the holdings will match its performance as well.
Since you cannot invest directly in an index, index funds are created to track their performance. These funds contain securities that mimic those found in a particular index, allowing investors to bet on their performance for a fee. One of the most popular index funds is the Vanguard S&P 500 ETF which closely mimics the S&P 500 index.
When compiling ETFs or mutual funds, fund managers try to create portfolios by mimicking the funds and securities of a particular index. By doing so, an investor can buy securities that are likely to fall and rise together with the stock market as a whole.
How to Invest in Index Funds?
Investing in index funds is quite simplistic. All you need is a brokerage account and you can select the index funds that might interest you. Here are the steps to invest in index equities.
Pick an Index
First and foremost, it is crucial to pick an index. As there are thousands of indexes available, the choice can be hard for an average investor. The S&P 500 is one of the most popular indexes which tracks the performance of the top 500 companies in the U.S stock market. Here is a list of some of the top indexes in the United States.
- Large U.S. stocks: S&P 500, Dow Jones Industrial Average, Nasdaq Composite
- Small U.S. stocks: Russell 2000, S&P SmallCap 600
- International stocks: MSCI EAFE, MSCI Emerging Markets
- Bonds: Bloomberg Barclays Global Aggregate Bond
Besides these broad indexes, you can also find sector indexes that track the performance of stocks of specific industries, national indexes that target stocks in a particular nation, style indexes that focus on fast-growing companies and various other indexes.
Choose the Right Index Fund
Once you have chosen a suitable index, you can find index funds that track the particular index. If you choose popular indexes like the S&P 500 or Dow Jones Industrial Average, you might get dozens of funds, all tracking the same index. If you are having trouble choosing between two or more index funds, you can filter your choices by asking some basic questions like-
- Which index fund most closely tracks the performance of the index?
- Which index fund has the lowest costs?
- Are there any restrictions on the index fund that prevent you from investing in it?
- Does the fund provider have other index funds that you’re also interested in investing in?
Answering these particular questions will help you narrow down your decision and pick the most suitable index fund for you.
Buy Index Fund Shares
You can buy index funds simply by opening a brokerage account and buying the funds that interest you. Another option is to directly open an account with a mutual fund company that offers an index fund you want to buy.
However, looking at the costs and features of an index fund incurs charges. Some brokers also charge extra for their customers to buy index funds. In this case, it is typically cheaper to go to an index fund company and open a fund account to buy a particular fund.
Still, many investors prefer to have all their holdings in a single brokerage account. This is because if you are interested in several index funds offered by different companies, the brokerage option is the best way to have all your investments within a single brokerage account.
Final Words
Market indexes essentially track the performance of a preselected group of investments. They also provide a broad representation of how a particular market is performing. These financial indexes serve as a benchmark to gauge the performance and movement of a specific market segment. Moreover, investors also utilise these indexes as a basis for portfolio or passive index investing. In the United States, the S&P 500 and the NASDAQ 100 are such indexes.
Frequently Asked Questions(FAQs)
Ans. An index fund is essentially an ETF or mutual fund that aims to mirror the performance of a particular index. This is done by creating a portfolio that mirrors the index itself. This strategy is called index investing and is a passive investment strategy since it doesn’t involve any active management or stock picking. According to experts, indexing strategies often work better than stock-picking strategies in the long term.
Ans. Indexes are useful in many ways and are primarily used as a benchmark to measure the investment performance of any given strategy. By understanding how a strategy fares relative to a benchmark, we can get a general idea about its true efficacy and performance.
It also provides investors with a simplified view of a larger market, without having to examine every single asset in that index. A sector-specific index can show the average trend of any particular sector.
Ans. In the United States of America, the S&P 500, the Dow Jones Industrial Average, the NASDAQ composite and the Russell 2000 are some of the top indexes. In the case of international markets, the Financial Times Stock Exchange 100(FTSE 100) Index and the Nikkei 225 are popular indexes in the British and Japanese stock markets respectively.
