A market index is a tracker that represents the changing price of a group of assets. Index providers create indexes using a variety of methodologies to track different groupings, such as a collection of bonds or companies from a certain region.
Investors can use indexes in different ways, such as taking the pulse of a specific market or making an investment decision. Market indexes can also be used as the basis for an investment product, like an exchange-traded fund (ETF). Note that one cannot invest directly in an index; rather, they’re used mostly for informational purposes.
Indexes that track groupings of stocks based on a shared characteristic are called stock market indexes. When someone talks about “the market” moving up or down, they’re generally referring to a stock market index moving up or down. Often, several stock market indexes will be cited along with the number of points and percentage increase or decrease that each index experienced.
Major U.S. stock indexes
Several major U.S. stock market indexes are often used as benchmarks and referenced in financial news. Here are a few of the most famous indexes:
- Dow Jones Industrial Average (DJIA). Also known as the Dow Jones or the Dow, this list tracks 30 of the largest U.S. companies.
- The Standard and Poor’s (S&P) 500 Index. The S&P 500 tracks the 500 largest companies from leading industries listed on U.S. stock markets.
- The Nasdaq Composite Index. Primarily focused on technology, the Nasdaq Composite Index is made up of over 2,500 companies based in the U.S. and abroad.
- The Russell 2,000 Index. The Russell 2,000 Index tracks 2,000 small-cap companies that are also part of the Russell 3,000 index.
Functions of stock market indexes
Investors, financial analysts, and fund managers may use stock market indexes in a variety of ways.
To measure market performance
A broad stock market index may be used to measure the market’s general performance. For example, the S&P 500, created in 1957, could be viewed as a stand-in for how the U.S. stock market is doing overall.
The Dow Jones, launched in 1896, is also sometimes used to measure market performance. However, it tracks fewer companies, and its price-weighting approach gives companies with high stock prices more influence on the Dow.
Different types of stock market indexes can also be compared to one another. For example, an analyst that covers a specific sector may want to compare a sector’s returns to a broad market index.
As the basis for index funds
Some ETFs and mutual funds are passively managed index funds that attempt to track a specific index. For example, the Fidelity 500 Index Fund (FXAIX) lets investors buy a fund that tries to mirror the S&P 500.
As a benchmark
Investors and fund managers may actively manage their investments or fund to try and beat, rather than mirror, an index. Often, they’ll compare their portfolio’s or fund’s returns to a benchmark to see how well they’ve performed. For example, a large-cap fund may use the S&P 500 as its benchmark, while a small-cap fund could use the Russell 2,000 Index as its benchmark.
How to read a stock market index
Stock market indexes are readily available online for review. But it’s important to understand what’s being presented and why the index was created. When looking up an index, investors may consider:
What the index tracks
Investors want to review what exactly the index is tracking to make sure it aligns with the information they’re after. An emerging market index or a fixed-income index might not give someone much insight into how well U.S. stocks are doing.
What comprises the index
More specifically, investors may want to review exactly which assets an index tracks so they know what it can tell them. Index providers may set specific eligibility requirements, such as the company having to be listed on a U.S. stock exchange and have a market cap above a certain point. Then, they may rank all the potential stocks before deciding which specific stocks to track.
How the index is weighted
A stock index assigns each stock it includes a weight, which determines how much that company can influence the overall index. Index providers use different weighting methods, including (but not limited to):
- Price-weighting. As with the Dow Jones, this method weights companies based on their current stock price. It’s an uncommon practice that gives companies with higher stock prices more influence on the index.
- Float-adjusted market-capitalization weighting. Used by the S&P 500 and Russell 2,000, this method is one of the most common weighting techniques. It weights companies based on the total dollar market value of their outstanding publicly traded shares. As a result, companies’ changing stock prices will impact the index proportional to the value of the company.
- Market-capitalization weighting. This method weights companies based on their size but doesn't exclude shares that aren’t regularly traded, such as those held by a company’s founders or executives. The method has fallen out of favor as indexes have shifted to using float-adjusted or free-float market-cap weighting.
- Equal weighting. Used by the S&P 500 Equal Weight Index, this method weights every company equally, regardless of stock price or size.
- Fundamental weighting. This method relies on other metrics to weight companies, such as their dividend yield or earnings per share. For example, index provider RAFI Indices, LLC uses its RAFI Fundamental Index methodology to create different indexes based on fundamental weighting.
It can be easier to understand why a stock market index goes up or down when investors know what is driving the change.
The bottom line
Stock market indexes can help investors and analysts track a basket of stocks. They can be helpful for understanding overall market performance and comparing individual or fund performance to a benchmark index. However, it’s also important to understand what goes into each index. Even two indexes that track the same industry or region could have different results based on their methodologies.
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