A stock index or stock market index is a measurement of a section of the stock market. It is computed from the prices of selected stocks (typically a weighted average). It is a tool used by investors and financial managers to describe the market, and to compare the return on specific investments.
Two of the primary criteria of an index are that it is investable and transparent : the method of its construction should be clear. Many mutual funds and exchange-traded funds attempt to "track" an index (see index fund) with varying degrees of success. The difference between an index fund's performance and the index is called tracking error.
Stock market indices may be classified in many ways. A 'world' or 'global' stock market index -- such as the MSCI World or the S&P Global 100 -- includes stocks from multiple regions. Regions may be defined geographically (e.g., Europe, Asia) or by levels of industrialization or income (e.g., Developed Markets, Frontier Markets).
A 'national' index represents the performance of the stock market of a given nation--and by proxy, reflects investor sentiment on the state of its economy. The most regularly quoted market indices are national indices composed of the stocks of large companies listed on a nation's largest stock exchanges, such as the American S&P 500, the Japanese Nikkei 225, and the British FTSE 100.
Other indices may be regional, such as the FTSE Developed Europe Index or the FTSE Developed Asia Pacific Index. Indexes may be based on exchange, such as the NASDAQ-100 or NYSE US 100, or groups of exchanges, such as the Euronext 100 or OMX Nordic 40.
The concept may be extended well beyond an exchange. The Wilshire 5000 Index, the original total market index, represents the stocks of nearly every publicly traded company in the United States, including all U.S. stocks traded on the New York Stock Exchange (but not ADRs or limited partnerships), NASDAQ and American Stock Exchange. Russell Investment Group added to the family of indices by launching the Russel Global Index.
More specialized indices exist tracking the performance of specific sectors of the market. Some examples include the Wilshire US REIT which tracks more than 80 American real estate investment trusts and the Morgan Stanley Biotech Index which consists of 36 American firms in the biotechnology industry. Other indices may track companies of a certain size, a certain type of management, or even more specialized criteria -- one index published by Linux Weekly News tracks stocks of companies that sell products and services based on the Linux operating environment.
Some indices, such as the S&P 500, have multiple versions. These versions can differ based on how the index components are weighted and on how dividends are accounted for. For example, there are three versions of the S&P 500 index: price return, which only considers the price of the components, total return, which accounts for dividend reinvestment, and net total return, which accounts for dividend reinvestment after the deduction of a withholding tax. As another example, the Wilshire 4500 and Wilshire 5000 indices have five versions each: full capitalization total return, full capitalization price, float-adjusted total return, float-adjusted price, and equal weight. The difference between the full capitalization, float-adjusted, and equal weight versions is in how index components are weighted.
An index may also be classified according to the method used to determine its price. In a price-weighted index such as the Dow Jones Industrial Average, NYSE Arca Major Market Index, and the NYSE ARCA Tech 100 Index, the price of each component stock is the only consideration when determining the value of the index. Thus, price movement of even a single security will heavily influence the value of the index even though the dollar shift is less significant in a relatively highly valued issue, and moreover ignoring the relative size of the company as a whole. In contrast, a capitalization-weighted (also called market-value-weighted) index such as the S&P 500 or Hang Seng Index factors in the size of the company. Thus, a relatively small shift in the price of a large company will heavily influence the value of the index.
Traditionally, capitalization- or share-weighted indices all had a full weighting, i.e. all outstanding shares were included. Recently, many of them have changed to a float-adjusted weighting which helps indexing.
An equal-weighted index is one in which all components are assigned the same value. For example, the Barron's 400 Index assigns an equal value of 0.25% to each of the 400 stocks included in the index, which together add up to the 100% whole.
A modified capitalization-weighted index is a hybrid between capitalization weighting and equal weighting. It is similar to a capitalization weighting with one main difference: the largest stocks are capped to a percent of the weight of the total stock index and the excess weight will be redistributed equally amongst the stocks under that cap. Moreover, in 2005, Standard & Poor's introduced the S&P Pure Growth Style Index and S&P Pure Value Style Index which was attribute-weighted. That is, a stock's weight in the index is decided by the score it gets relative to the value attributes that define the criteria of a specific index, the same measure used to select the stocks in the first place. For these two indexes, a score is calculated for every stock, be it their growth score or the value score (a stock cannot be both) and accordingly they are weighted for the index.
One argument for capitalization weighting is that investors must, in aggregate, hold a capitalization-weighted portfolio anyway. This then gives the average return for all investors; if some investors do worse, other investors must do better (excluding costs).
Investors use theories such as modern portfolio theory to determine allocations. This considers risk and return and does not consider weights relative to the entire market. This may result in overweighting assets such as value or small-cap stocks, if they are believed to have a better return for risk profile. These investors believe that they can get a better result because other investors are not very good. The capital asset pricing model says that all investors are highly intelligent, and it is impossible to do better than the market portfolio, the capitalization-weighted portfolio of all assets. However, empirical tests conclude that market indices are not efficient. This can be explained by the fact that these indices do not include all assets or by the fact that the theory does not hold. The practical conclusion is that using capitalization-weighted portfolios is not necessarily the optimal method.
As a consequence, capitalization-weighting has been subject to severe criticism (see e.g. Haugen and Baker 1991, Amenc, Goltz, and Le Sourd 2006, or Hsu 2006), pointing out that the mechanics of capitalization-weighting lead to trend-following strategies that provide an inefficient risk-return trade-off.
Also, while capitalization-weighting is the standard in equity index construction, different weighting schemes exist. First, while most indices use capitalization-weighting, additional criteria are often taken into account, such as sales/revenue and net income (see the "Guide to the Dow Jones Global Titan 50 Index", January 2006). Second, as an answer to the critiques of capitalization-weighting, equity indices with different weighting schemes have emerged, such as "wealth"-weighted (Morris, 1996), "fundamental"-weighted (Arnott, Hsu and Moore 2005), "diversity"-weighted (Fernholz, Garvy, and Hannon 1998) or equal-weighted indices.
There has been an accelerating trend in recent decades to invest in passively managed mutual funds that are based on market indices, known as index funds. SPIVA's annual "U.S. Scorecard," which measures the performance of indices versus actively managed mutual funds, finds the vast majority of actively managed mutual funds underperform their benchmarks. One study claimed that over time, the average actively managed fund has returned 1.8% less than the S&P 500 index - a result nearly equal to the average expense ratio of mutual funds (fund expenses are a drag on the funds' return by exactly that ratio). Since index funds attempt to replicate the holdings of an index, they eliminate the need for -- and thus many costs of -- the research entailed in active management, and have a lower churn rate (the turnover of securities which lose fund managers' favor and are sold, with the attendant cost of commissions and capital gains taxes).
Indices are also a common basis for a related type of investment, the exchange-traded fund or ETF. Unlike an index fund, which is priced daily, an ETF is priced continuously, is optionable, and can be sold short.
A notable specialized index type is those for ethical investing indices that include only those companies satisfying ecological or social criteria, e.g. those of The Calvert Group, KLD, FTSE4Good Index, Dow Jones Sustainability Index, STOXX Global ESG Leaders Index, several Standard Ethics Aei indices and Wilderhill Clean Energy Index.
In 2010, the OIC announced the initiation of a stock index that complies with Islamic law's ban on alcohol, tobacco and gambling. Other such equities, such as the Dow Jones Islamic Market World Index, already exist.
Another important trend is strict mechanical criteria for inclusion and exclusion to prevent market manipulation, e.g. in Canada when Nortel was permitted to rise to over 30% of the TSE 300 index value. Ethical indices have a particular interest in mechanical criteria, seeking to avoid accusations of ideological bias in selection, and have pioneered techniques for inclusion and exclusion of stocks based on complex criteria. Another means of mechanical selection is mark-to-future methods that exploit scenarios produced by multiple analysts weighted according to probability, to determine which stocks have become too risky to hold in the index of concern.
Critics of such initiatives argue that many firms satisfy mechanical "ethical criteria", e.g. regarding board composition or hiring practices, but fail to perform ethically with respect to shareholders, e.g. Enron. Indeed, the seeming "seal of approval" of an ethical index may put investors more at ease, enabling scams. One response to these criticisms is that trust in the corporate management, index criteria, fund or index manager, and securities regulator, can never be replaced by mechanical means, so "market transparency" and "disclosure" are the only long-term-effective paths to fair markets. From a financial perspective, it is not obvious whether ethical indices or ethical funds will out-perform their more conventional counterparts. Theory might suggest that returns would be lower since the investible universe is artificially reduced and with it portfolio efficiency. On the other hand, companies with good social performances might be better run, have more committed workers and customers, and be less likely to suffer reputational damage from incidents (oil spillages, industrial tribunals, etc.) and this might result in lower share price volatility. The empirical evidence on the performance of ethical funds and of ethical firms versus their mainstream comparators is very mixed for both stock and debt markets.
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