Understanding how sharemarket indices work is a key to understanding how to use investments like Exchange Traded Funds (ETFs) many of which aim to replicate indices. We’re all familiar with the index of a textbook, but what does a sharemarket “index” tell us about the sharemarket?
Many investors are exposed to the concept of an ‘index’ when they see media reports of a particular index moving up or down:
News reports such as this one report on the performance of the Australian ‘index’
The term “index” is used by investment professionals to describe the value of the components of the overall sharemarket. Wiktionary defines “index” when it’s used this way as:
“a single number calculated from an array of prices or of quantities.”
The very first sharemarket index was designed to be used in just this way.
Launched by Charles Dow in 1896, the original “Dow Jones” index was calculated by taking the overall prices of the 12 largest companies in the US, and then dividing that number by 12. So the Dow Jones index in its early days was really just a measure of the average price of the top 12 stocks – and was a simple way to see if the overall sharemarket was rising or falling in price terms.
Basing an index calculation on the average price of its components was superceded when it became obvious this method ignored the “size” of different companies. A very large company’s price moving up or down, such as BHP or Rio Tinto, will have far more of an impact on the movement in the overall sharemarket than if a very small company like the Brisbane Broncos (the rugby league team is listed on the ASX) moves in price.
Most sharemarket indices are calculated based on the “market capitalisation” of a stock, as a percentage of the overall value of the entire market. For example, a traditional Australian sharemarket index like the S&P/ASX 200 index measures:
- The overall value of the top 200 shares traded on the ASX – calculated by using the market price of each of the top 200 shares, and multiplying that price by the number of shares on issue for each of those companies (this measures the “market capitalisation” of each stock); and also measures
- The proportional percentage of each component stock within the overall index value.
For example, if the overall value of an index is $100 billion, and the overall value of the largest company in that index is $10 billion, then that largest stock will represent 10% of the overall index.
Used this way, an index shows what proportion of shares in a particular company are required – relative to the other shares in the index – in order to build a diversified portfolio which tracks the performance of that index. Now to do this oneself would of course be very onerous – imagine having to buy 200 different stocks and weight them regularly to ensure your portfolio remained ‘in balance’. This is one of the reasons why ETFs are so popular globally. Investors in ETFs which track equity indices are able to access all the components of that index as simply as buying any share.
So far we’ve discussed market capitalisation weighted indices. However, modern sharemarket indices can be calculated in many different ways – each using a different approach to measuring and investing in the sharemarket. For example, “Fundamental” indices are calculated using fundamental measures of the value of a specific company relative to the other stocks in the index. This approach uses the simple idea that it can be efficient to build an index based on the “economic footprint” of a company – eg how much it sells, what dividends it pays, etc.
Comparison of the FTSE RAFI Australia 200 (fundamental) and the S&P/ASX200 (market cap) indices. Click here to learn more about Fundamental Indexing. As at 30 September 2013. Source: Bloomberg.
The core idea of using an index for investment purposes is as a simple way to determine which stocks – and in what amounts – an investor might want to buy in order to achieve a return in line with the overall performance of the index and market which the index tracks.