What are indices?
Chapter 1: Intro
You’ll often hear about stock market indices on TV news reports and in the financial pages. So what are they – and why do they matter?
The reason why they are mentioned so often is that they act as an indicator for many important things. These include (among other things):
- Stock market confidence
- Business confidence
- The health of the economy
- The health of our investments in stocks and shares.
The basic rationale is that if there is confidence, investors (such as pension funds, insurance companies, investment funds and private investors) will buy shares and the overall level of stock market prices will tend to rise.
If they don’t have confidence, then prices will tend to fall – as investors sell their stocks and either hold on to their cash or invest in something else.
This is true – but it’s also a slightly simplistic view of the indices' meaning. In reality, many other factors will influence stock market behaviour – for example, interest rate changes, national budgets, political events, trade and economic performance announcements and so on. And that’s why it is so difficult to know which way ‘the market’ will go next.
Chapter 2: How are indices compiled?
Indices (also called ‘indexes’) are formed by selecting a group of companies, whose shares are listed on a public stock exchange.
So, for example, the FTSE 100 is compiled from the 100 largest companies listed on the London Stock Exchange measured by the market capitalisation (or ‘market cap’). That is, the number of shares they’ve issued, multiplied by the price of those shares.
These large companies are also referred to as ‘blue chip’ companies. The level of an index is calculated by reflecting the aggregate price changes in a number of points and it is also expressed as a percentage.
Other indices employ a similar approach. The S&P 500 includes the 500 largest companies listed on the New York Stock Exchange or the NASDAQ. Dow Jones Industrial Average (‘The Dow’) is based on the 30 largest stocks listed on the same exchanges.
Companies join and are dropped from an index as their market cap increases or falls. The constituent index companies are reviewed periodically to ensure that they qualify to be included in an index. Remember that the London Stock Exchange also has smaller companies indices such as the FTSE 250 or FTSE 350. These are compiled in a similar fashion.
Chapter 3: How to invest?
When investors want to invest in an index, they can buy into a (‘tracker’) fund that holds the same stocks in proportion to the way the index is compiled.
Investment funds, including mutual funds, manage this process and invest on behalf of their investors. They also collect the dividends paid on the shares for the investors and distribute them (or reinvest them). And they take a fee for doing this.
An increasingly popular form of index investment, are stock market listed exchange traded funds (ETFs). The charges levied by the managers of ETFs are much lower and the process of buying into them or selling out is much quicker and easier.
There are number of derivative products that ‘derive’ from indices – and you can buy options or futures on stock market indices such as the FTSE 100 and or S&P 500. Essentially these are tools for either hedging against fluctuations in the level of the indices, or betting on whether they will rise or fall, depending upon what you’re looking to achieve with your investment.