In market news last Friday, the Dow dropped 503.5 points with the tech heavy Nasdaq plummeting 349.5 points, and the S&P 500 slid 1.9%. (Yahoo)
I’m paraphrasing slightly but what does it mean when you see headlines like this at the end of the day or at the end of the week.
The Dow Jones industrial average, the Nasdaq 100 and the S&P 500 are all indices.
They are not the only ones though. There is the Russell 2000, Wilshire 5000, MSCI EAFE, MSCI ACWI, Bloomberg US Aggregate Bond Index, FTSE 100 and many, many more. An entire alphabet soup of names and acronyms exist out there.
What are they for?
Simply put indexes are designed to give a indication of how a certain aspect of the market is doing.
The one thing that everyone who works in finance, accounting, or economics likes to do is to keep track of things.
- How much did I spend last month?
- How much was the cost of gas this time last year?
- And how much is the S&P 500 up this year?
Indices are no different, they are simply a way to easily tell how a certain aspect of the market is doing.
Instead of looking at the stock price of individual companies. Indexes aggregate the daily movements of a bundle or group of stocks together. This way investors can easily tell which direction the market is moving, or at least that segment of the market is moving.
COmponents
How do indexes determine what is included in their index?
Each index does it a little differently but usually they are trying to track a certain segment of the market. To track that, they pick stocks that they think most accurately represent that segment.
The S&P 500 is designed to track the performance of large cap US stocks. To accomplish this the S&P 500 is made up of 500 of the largest companies in America.
Some indexes have the same segment they are trying to track but come to different conclusions on what to include. The Russell 1000 is also designed to track the performance of large cap US stocks but it includes 1000 of the largest companies in the US instead of 500.
While the Russell 1000 has twice as many companies it tracks the overall performance is not that different from the S&P 500
The reason the Russell 1000 and the S&P 500 are very similar, even thought the companies in them are not, is how they are weighted.
Market cap weighted vs. price weighted vs. equally weighted
After an index has decided what stocks or securities they want to track they then have to decide how to group them all together. There are three different ways an index can decide how much of each stock or holding they want to have.
market cap weighted
In this type of index, the largest companies by market cap get the largest weighting. This is by far the most common type of weighting for an index. The S&P 500 does it this way the Nasdaq 100, most other indices do this as well.
To illustrate this the five largest companies in the US are
| Company | Market Cap |
| Apple | $ 2,815,912,574,976.00 |
| Microsoft | $ 2,245,312,643,072.00 |
| Alphabet (Google) | $ 1,818,780,893,184.00 |
| Amazon | $ 1,608,969,879,552.00 |
| Tesla | $ 937,240,850,000.00 |
Their respective weightings in the S&P 500 is
A very similar list. The largest companies in the US have some of the highest weighting in the S&P 500.
price weighted
The other way to decide how much should be weighted to each holding is price weighted. This is less common than market cap weighted. The Dow Jones Industrial average is one of the most famous price weighted index.
A price weighted index works by adding up the share price of all of the companies in the index and then dividing by the number of companies in the index.
In this type of index, the companies with the highest share price are awarded the highest weighting not the companies with the highest market cap.
For example the companies with the highest weighting in the Dow are
| Stock | % Weight in the Index |
| UnitedHealth Group | 9.06 |
| Goldman Sachs | 6.79 |
| Home Depot | 6.60 |
| Microsoft | 5.65 |
The stock prices of these four companies are
| UnitedHealth Group | 480.05 |
| Goldman Sachs | 360.05 |
| Home Depot | 350.09 |
| Microsoft | 299.50 |
Even though the market cap of United Health Group is much smaller than Microsoft, United health group still makes up a larger portion of the index because its stock price is higher.
One of the downsides of this type of index is that stock splits can have a major impact on the weighting of the index.
When Apple stock split in 4-1 in 2020, it went from one of the largest portions of the Dow to the 13th largest. Meanwhile its weighting in the S&P 500 did not change at all because its market cap did not change.
Equally weighted index
The last and least popular way to weight an index is equally weighted. Exactly as the name sounds, each holding in the index has the exact same weight.
If there are 20 holdings in an index each position would have a 5% weighting
If the S&P 500 was an equally weighted index, both Apple the largest and Norwegian Cruise line one of the smallest companies in the index would both have a weighting of .2% of the overall index.
SO what?
The next time you see a headline like this, know that all they are really trying to say is how a certain aspect of the market is doing.
Until Next time,
GT
P.S. Let me know what you think or if you would like more details on certain indexes
Fun Fact: And yes there are 28 instances of the word Index and Indexes with a few indices thrown in for good measure