Understanding Stock Market Indexes (and Index Trading)

Thousands of individual stocks trade every day on various stock markets around the world. There are a number of stock indexes that track the movements of stock markets.

The simplest stock indexes (for example, the Dow Jones Industrial Average (DJIA) in the US) are price-weighted indexes. To calculate the value of the index you add up the price of the 30 individual stocks. But over time, the stocks in the index have changed and some of the companies have split their shares; to correct for these changes there is a divisor, so the sum of the prices of the shares in the DJIA is divided by approximately 0.123 (see here for calculation). This means that a $1 change in the price of a stock in the index results in a roughly 1/.123 or 8.1 point change in the index.

One problem with price-weighted indexes is that a company’s influence in the index depends on the per share price and not the value of the company. In the Dow Jones Industrial Average, Merck, with a share price (as I write) around $35, has a larger weight in the index than General Electric which trades around $30, despite GE’s much larger market capitalization (GE has many more shares outstanding; the total value of the GE shares is around $300 Billion compared to Merck’s roughly $75 Billion).

There is a second class of indexes called value-weighted indexes that assign a value in the index proportional to the size of the company. The Standard and Poors 500 is such an index; recently (December 2007) Exxon, the largest company in the index had a weight of almost 4%, General Electric had a weight of almost 3% and Microsoft around 2.5%; the other 497 companies combined have a weight of only 91% of the index.

Some investors find it useful to own indexes. Individual investors who wish to diversify their portfolios can buy all the firms in an index; this allows individuals to reduce the risk of their holdings (the variability of a group of stocks tends be smaller than the variability of individual stocks). Using index funds individuals can invest in the broad US stock market (say, the Wilshire 5000 index which includes most traded US stocks) or a specific sector (say, the iShares S&P North American Technology Sector Index Fund which tracks US traded technology companies).

Institutional investors can use index funds to hedge their portfolios; hedge funds often use these funds to reduce the correlation between the return on their funds and other indexes.

Investors can purchase these indexes in various ways. You can try to buy all the stocks, but unless you are a very large investor it is costly to acquire different amounts of 500 companies. More realistically, you can buy either mutual funds or ETFs.

A mutual fund that tracks the S&P 500 may not buy all 500 companies either, as the improvement in tracking the index from owning small amounts of the smallest companies is minimal. The important distinction between a mutual fund and an ETF for an investor is that mutual funds have only one price per day, set shortly after the end of the trading day, while ETFs are traded throughout the day. A mutual fund investor who buys the fund acquires the shares at that price and can sell it only at the end of the day price at a later date. These funds are designed for medium to long term investors, and not for traders who wish to buy and sell at different times during the day. The basis for evaluating such funds is how their return compares to that of the index, which tends to improve with the size of the fund (bigger funds, lower fixed costs, better tracking of the index).

An ETF (exchange traded fund) is a portfolio of stocks that is designed to track an index (see here for the SPY ETF designed to track the S&P 500) that is traded on an exchange. So you can buy the ETF at 11am and sell it at 2pm if you want. For many small investors it is more convenient to hold mutual funds (for example funds will allow you to invest smaller amounts every month) but some investors find the flexibility of ETFs more important.

There are also futures traded on the S&P 500. Like any future these contracts are traded at a futures exchange (in Chicago at the CME) and not on the stock exchange (see here for more information). The futures contract is equivalent to trading the portfolio of stocks for delivery at a future date. In other words, in any month, you can arrange to buy or sell the index in the next month or some month after that. There is a fairly close relation between the price of the future and the index (price of future equals price of index times (1 + appropriate interest rate)). Futures require much smaller initial investments than stocks, and trade after stocks have stopped trading (S&P index futures trade more or less continually from Sunday night US time until Friday afternoon). So one can follow the market even when the stock exchanges are closed by watching the price of the futures markets, although the relation between the end of the day cash and futures price must be carefully examined (see here for a discussion of how “fair value” is calculated, and how to examine the difference between the price change from the closing price relative to fair value).

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