What Exactly is an Index?

- Sure all this index talk sounds great, but what really is an index and how does it represent companies in the market?

The most simple way to explain an index is that it is a list of stocks.

You have common indexes such as the Dow Jones Industrial Average (DJIA), Standard & Poor's 500 (S&P 500) and Nasdaq that consist of the largest public companies in the U.S. In theory, you could create you own index and track some segment of the market. For example, you could create a Canadian banks index, decide on a weighing system and track it over time to depict how banks as an index unit are doing. Indexes provide a simple way of tracking a group of stocks without having to process too much information. It's all about reducing sample size to gain a general image of market dynamics.

- So where did this all start? And how does it actually work?

The first Index was created in 1896 by Mr. Dow and appropriately named the Dow Jones Industrial Average. At the time, it consisted of 12 of the biggest companies in America (today it consists of 30). The value of the DJIA was established by adding the the prices of the 12 companies together and dividing by 12, providing a simple average. While there are flaws in doing this, it was a simple and efficient enough method at the time. 

It is now more common to use a market capitalization (market cap = share price * number of shares outstanding) method of weighing companies within an index. For example, if a company has a market cap of $5,000,000 and the complete value of all stocks in the index is $500,000,000, this company would represent 1% of the index. Let's say the stock dropped by half in value, while all other stocks remained unchanged, the index would drop by 0.5% in representative value. To calculate the actually price of an index, an index-specific divisor is used. The divisor accounts for structural changes within companies, such as share repurchases and mergers. In the example of the S&P 500, the sum of all 500 market caps are divided by the divisor, giving the index level (or value of the index). To give an idea, the current index level of the S&P 500 is $1880 and has a 52-week range of $1812-$2134.

- So why does knowing this matter?

As an investors, its always beneficial to be knowledgeable on what you're buying. Understanding how an index price fluctuation actually relates to individual stocks can be beneficial (and vice versa). You may also be interested in assessing how heavily weighted some of your favourite companies are within their respective index. Understanding how an index is designed can also help you asses the effectiveness of your index fund. For example, the three biggest companies in the S&P 500 are: Apple, Google (Alphabet) and Microsoft. An effective index fund should probably hold these companies as their top holdings, as they will have the most influence of any company on price fluctuations of the index (remember they are weighed by market cap!).

Knowing how an index is computed also depicts how an index could be down over a given time period while most of the stocks within the index could actually be up. This could be the case if a few stocks (or specific industries) in the index were down significantly, bringing down the complete index.

- How does this relate to index funds?

Index funds track these major indexes by purchasing stocks of many (sometimes all) of the companies within the index. You can expect that your index fund will have top holdings of the largest market caps within an index. Looking back to our article on the top holdings of e-series, for TDB 902 (S&P 500 index fund), the top 3 holdings were in fact:

Apple Inc. (3.3%)
Alphabet Inc. (2.5%)
Microsoft Corp (2.5%)

The metric used to asses how well an index fund tracks its target index is R-squared. R-squared is a common statistics metric that asses the strength of correlations between two sets of data. The values range from 0-100%, where 100% would present a perfect fit. When assessing the effectiveness of an index fund, you'd expect this value to be in the high nineties. For example, the 1-year R-squared value of TDB 902 is 99.00%, its 3 year value is 98.70% (Yahoo link). This signifies the index fund has been very accurate at tracking the S&P 500.

If you have any questions regarding indexes, comment below! Happy investing!


-Yinvestors.



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