Stock Indexes: Very Useful, But Not Well Understood

Stock indexes – imaginary portfolios representing a broad market or sectors of a larger market – are among the most useful tools for people who invest in stocks. But, while they are often cited in the media and elsewhere, not everyone knows how indexes are used or how they are compiled.

The following is a short primer intended to give you the basics.

How Are Indexes Used?

Stock indexes are used in three main ways:

• Indexes measure how the overall stock market – or some segment of it – is doing. The most common indexes used to track the overall market are the S&P 500 Stock Index and the Dow Jones Industrial Average. Others, such as the Russell indexes, measure the performance of certain kinds of stocks, such as value or growth stocks, and those of small, medium and large companies.
• Indexes are useful as a kind of yardstick to measure how a  stock - or portfolio of stocks - is performing compared to the broad market  or sector of the broad market composed of similar stocks.  A portfolio that "beats the market" – in other words, performs better than a relevant index – is generally considered to be doing well, while a portfolio that lags the index significantly could require some attention.
• Investors also can invest in indexes via mutual funds and other vehicles set up to mimic the index in the real world. Such investments generally have low costs and carry far less risk of lagging the market. On the other hand, they don't beat the market, either.

The S&P 500

The most widely-used Index is the S&P 500 Stock Index, which was introduced in March 1957.  This index is "float weighted" meaning that companies with a larger "float" – the number of shares available for public trading times the share price – are more heavily represented in the index.  

Companies with a larger weighting (for example, ExxonMobil – which has a weighting of 3.3 percent of the Index and General Electric, which has a weighting of 3 percent), will have a larger affect on movement in the Index than smaller companies. Hence, the stock price of Starbucks – which has a weighting of only two-tenths of one percent – has a relatively small impact on the S&P 500.

Who selects stocks for inclusion in the Index?  The S&P 500 Index Committee is responsible for selecting stocks for inclusion into the Index.  Surprisingly, the committee uses only 5 main criteria – and they're pretty straightforward:

1. Liquidity:  The committee wants the benchmark to be "investable," so it selects stocks with sufficient liquidity and float.
2. Fundamental analysis: The criteria are:  "four quarters of positive net income on an operating basis."
3. Market capitalization: For the S&P 500, there are no market capitalization restrictions, per se. But   "the guiding principle for inclusion in the S&P 500 is leading companies in leading US industries."
4. Sector representation: The committee tries to keep the weight of each sector – such as financial, healthcare and technology companies – in line with the sector weightings of the overall.
5. Lack of representation: The S&P excludes or removes companies once it determines that: "If the index were created today, this company would not be included   because it fails to meet one or more of the above criteria."   

The Russell Indexes

The Russell Indexes were launched in 1984 and are managed by the Russell Investment Group. Russell forms its indexes by listing all US companies in descending order by market capitalization.

 The largest 3,000 stocks constitute the broad Russell 3000 Index. The top 1,000 of those companies make up the large-cap Russell 1000 Index, and the bottom 2,000 (the smallest companies) make up the small-cap Russell 2000 Index. 

Unlike the S&P 500 Index, the Russell Indexes are rebalanced or "reconstituted" annually.  The reconstitution consists of updating the list of the largest 3,000 companies and assigning them to the appropriate indexes.

The Dow Jones Industrial Average

The oldest and most recognized "index" isn't even an index; it's an "average":  the Dow Jones Industrial Average (DJIA).

The DJIA is a "price-weighted" average.  Thus, higher-priced stocks in the Dow will have a larger affect on movements in the lower-priced stock.

The DJIA was first published in May of 1896 and represented the average of 12 stocks.  On Oct. 1, 1928, it was expanded to include 30 stocks. The composition of the DJIA has remained representative of American industry
Today, the DJIA has strong representation in financial, techonolgy and healthcare stocks showing evidence of our shift from heavy manufacturing  to technology and service industries. Among the companies included are: 

• American Express
• Citigroup
• Hewlett-Packard
• Intel
• IBM
• Microsoft
• Pfizer
• Merck

Of the original 12 Dow Jones Industrial Average stocks, only one remains part of the Average today: General Electric.

How can index funds be used in your portfolio?

"One way is to combine them with your favorite actively-managed mutual funds," said Mark B. Robinson, presenter for the Investor Education @ your library program. "This allows you to realize returns that closely track the market through your index funds while also allowing the potential for 'market-beating' returns from your actively-managed funds. And if your favorite actively-manage funds under-perform the market, the market-matching return from your index funds will offset the underperformance. Combining index funds with your favorite actively-managed funds reduces your overall fund expenses, too. "