Overview of Stock Indices
A stock Index, also known as an equity Index, provides a way of tracking part of the stock market.
The reason why we have equity indices is to get a single number that sums up a whole segment of the stock market. A market segment may be identified in different ways some examples are:
Stocks/equity are only one of the asset classes that indices track and if you learn more about these and other asset classes then take a look at our course Asset Classes For Investors
Why Are Equity Indices Useful
Equity Indices are useful because they allow asset managers to easily invest in a market segment by just passively tracking the equity index.
The biggest companies which provide equity indices are:
These companies make money by generating license fees paid by asset management companies (like Vanguard and Blackrock) who track their index or use it as a benchmark
The licenses allow asset managers to buy the same stocks that make up the index and in the same percentage (weight)
Equity indices are weighted in two main ways.
Price Weighted Indices
Price weighting works by holding more of the stock that costs the most.
This is a terrible idea because if a few companies have a high share price then they dominate the index for no particular reason. It may be difficult to buy and sell these stocks which increases the costs of trading and in turn the cost of buying the index.
Examples of price-weighted indices are the Dow Jones Industrial Average and the Nikkei 225.
Market Cap Weighted Indices
Market capitalised (cap) weighted indices account for almost every other index.
They tend to be the most successful indices and effectively what they do is buy a higher percentage of the larger companies' stocks.
The size of a company (market cap) is worked out by calculating the number of buyable shares multiplied by the price per share.
This has the advantage that big company stocks are usually more liquid (easier to buy and sell) which makes them cheaper to trade and in turn reduces the price of tracking the index.
An example of a market cap index is the MSCI All Country World Index.
In the table below you can see the largest 10 constituents of the MSCI All Country World index. Notice how the weight for bigger stocks such as Apple (3.72%), the biggest company in the world, are bigger than the weight for smaller stocks such as Taiwan Semiconductor (0.71%)
Total Return Indices
If you own stocks there are two ways they can make you money. One way is when the price of the share goes up and you can sell it at a profit. The other way is by the Company paying it’s shareholders dividends, which is a percentage of the earnings decided by the company management.
Some indices are total return indices which means they assume dividends are reinvested but this is quite unusual, an example of one is the German DAX.
Because total return indices account for capital gain and income you need to find a way to fairly compare investments. One way of doing this is to find an ETF that tracks the index which is an accumulating version of the fund as income versions only show capital gain.
How Are Equity Indices Structured?
Companies that create equity indices are always trying to come up with new things to track. Often these companies arrange their indices in hierarchies.
Below you can see the structure for MSCI’s market cap weighted indices.
Notice that the global All Country World (ACWI) and Frontier Markets index incorporates all the stocks beneath it. Then with each split, the hierarchy narrows the scope of markets it incorporates.
Performance of Stock Indices
The performance of different stock indices does vary. Even though over the long-term equity tends to rally, that's not the same for every country.
For example, If you look at the FTSE MIB, which is the Italian equity index in the graph below, this has not grown since 2001. This reflects Italy’s lack of economic growth which has lagged behind its European counterparts.
A few sites provide regional valuations for free but not with the histories which are really needed because some regions are consistently cheap/expensive relative to one another
Risk vs Return of Equity Indices
There’s a huge difference in risk and return between regions. The US and China have done well since 2005 but past performance is no guarantee of future performance.
Below is a risk and return graph for different regions’ stock indices.
Correlation of Stock Indices
Correlations between equity anywhere tends to be high, but generally the clustering is geographic e.g. European regions tend to have a high correlation with one another, as do Asian countries.
In the diagram below the indexes that are closest together on the tree are the most correlated and you can see that those that are geographically close tend to be clustered closely together.
If you want to find out more about building a diversified portfolio take a look at my blog How To Build a Two Fund Portfolio
List of Stock Indices
Below is a list of commonly used indices and where they are based.
- IBOV Bovespa Stock Index (Brazil)
- 000300 CSI 300 Index (Shanghai)
- XIN0 FTSE China 50 Index
- RTSI Russian Trading System Index
- BSE100 S&P BSE 100 Index (Mumbai)
- 000001 SSE Composite Index (Shanghai)
- CAC CAC 40 (Paris)
- DAX DAX Xetra (Germany)
- DJI Dow Jones Industrial Average
- N100 Euronext 100
- UKX FTSE 100
- MCX FTSE 250
- NMX FTSE 350
- AIM1 FTSE AIM 100
- AXX FTSE AIM All-Share
- AIM5 FTSE AIM UK 50
- ASX FTSE All-Share
- NSX FTSE Fledgling
- SMX FTSE SmallCap
- TASX FTSE TechMARK All Share
- T1X FTSE TechMARK Focus Index
- HSI Hang Seng (Hong Kong)
- IXND NASDAQ 100
- IXIC NASDAQ Composite
- NIK Nikkei 225
- GSPC S&P 500SMI Swiss Market Index
- AW12 FTSE All-World Index - Europe ex UK
- AW01 FTSE All-World
Size of Equity Markets By Country
Below is a pie chart of the relative size of each county’s equity market. These are the country weights in MSCI’s All Country World Index (ACWI)
In terms of size, the US dominates completely by market capitalization e.g. the market capitalization of Apple ($1.9 trillion) is twice the size of the entire UK equity market (about $844 billion)
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