Stock Indexes

This article discusses some of the major stock indexes in the US including their history and relevance to today's investors. Stock indexes, or stock market indexes, are lists of stocks and statistics that reflect the composite value. Broad-based indexes such as the Dow Jones Industrial Average or the S&P 500 in the US are representative of the performance of the entire market. For this reason, these indexes are closely watched as a reflection of how investors view the state of the economy. Specialized indexes allow investors to track portfolios for specific sectors of the overall market which are much more manageable. Specialized indexes track performance of stock portfolios that are grouped by common attributes such as market or size of company. This essay discusses some of the major broad-based indexes and current trends surrounding the use of traditional indexes. Stakeholder issues are discussed from the standpoint of what current stock indexes provide for managers, investors and policy makers. A new generation of stock indexes is emerging to meet additional stakeholder demands and these are discussed along with other emerging trends in the use and creation of stock indices.

There is no perfect stock index. Indexes are developed to gauge performance of groups of stocks. As the proliferation of stocks increases in our global economy, the greater the need to develop new indexes that help stakeholders to monitor performance of certain stock segments.

The Dow Jones Industrial Average (DJIA) index was started in 1896 by Charles Dow and indexed 11 stocks at its inception. Today, the DJIA tracks 30 stocks that are known as "blue-chip" stocks. The "blue-chip" companies that are indexed in the DJIA are considered industry leaders in a variety of segments including: Energy, banking communications, retail and entertainment.

Methods for Stock Indexing

The Dow indexes its stocks using a price-weighted system. Price-weighted indexing means that the total prices of all stock are added together and divided by the number of stocks in the index. Market capitalization is the method of indexing used by many of the other major indexes such as the NASDAQ and S&P 500. Market capitalization takes into account total market value and not just price. Market capitalization is felt by many to be a better indicator of overall market performance. The other major criticism of the Dow is that because it only tracks 30 stocks (out of the thousands of stocks on the market), it isn't considered very representative of the market as a whole.

NASDAQ, Standard and Poor's 500 & Wilshire 5000

NASDAQ

The NASDAQ index was started in 1971 and is a market-weighted index that tracks a large number of technology stocks (sometimes referred to as "tech heavy"). The NASDAQ does track over 5000 technology related stocks and as such, is a good representation of stocks from the tech sector. However, the NASDAQ doesn't do as good a job of indicating the markets as a whole. Other drawbacks cited for the NASDAQ are that the index includes a number of small companies that tend to increase volatility in the market.

Standard and Poor's 500

Another major stock index is the Standard and Poor's 500 (S&P 500) which indexes "large cap" companies. These companies have market capitalization of over $10 billion as calculated by the companies number of shares multiplied by the stock price. It's important to remember that stock prices change over time and therefore the companies referenced in the index may also change. The "large cap" or "big movers" are indicative of company size (Wayman, 2007).

Wilshire 5000

The Wilshire 5000 is considered the "total market index"; it was started in 1974 by Wilshire Associates. The index came about due to the availability of computer technology that allowed for efficient indexing of large amounts of statistical data. The Wilshire has been called the "nation's broadest-based index" and is thought by many to be the most accurate reflection of the overall market. The index now includes stocks from 6700+ firms (essentially every public firm and is therefore highly representative of the overall market)-not the 5000 that are stated in the index name. The Wilshire is not often cited in the financial press because the index is considered by many to offer "too broad" a view of the US markets. The Wilshire is so diverse that it is not easy to tell which sectors are moving the market (ex: tech, industrial, small or large).

The Dow Jones, NASDAQ, S&P 500 and Wilshire indexes are just a representative four out of the hundreds of stock indexes that are now available to benchmark stock performance. The first three (DJIA, NASDAQ & S&P) are very visible, broad-based indexes and as such, are often cited for financial reporting purposes as good indicators of investor confidence in the US economy. Current literature indicates that stakeholders such as money managers, clients/investors and policy makers need to monitor other indexes to make sound decisions about stock market investments and to meet their respective objectives. There is no consensus from stakeholders about which index is best; all have benefits and drawbacks. Investors and fund managers are continuously on the lookout for new and better designed indexes that will help to monitor investment portfolios.

Applications

Evaluations of Stock Indexes

By definition, a stock index is a representative sample or snapshot of stocks that is a subset of the larger universe of stocks. There are literally hundreds of stock indexes available for the individual investor or market fund manager to monitor on a daily basis. Yet, even with the proliferation of indexes, the big three (Dow Jones Industrial Average, S&P 500 and NASDAQ Composite) "rule the headlines" and serve as the major sources of stock market analysis for most investors and managers (Wayman, 2007). There is plenty of criticism in the industry and media about the shortcomings of the major US indices in their ability to provide real insight into many markets.

Pros of the Major US Indices

The DJIA, S&P and NASDAQ indexes are useful tools for tracking market trends and historical perspectives. Investors who look at how indexes react to economic trends over time will have a better understanding of why trends occur. These indexes can be useful tools for helping investors make better investment decisions.

Cons of the Major US Indices

The major US indexes are subject to calculation bias. Most indexes (with the exception of DJIA) are market-weighted indexes. This simply means that stocks of larger companies with larger market presence have a larger influence on the index. Large stocks influence the index much more than small companies (with smaller market share-market cap). Many feel that if the index is weighted toward large company stocks, the index can't really describe the health of the overall index. This over-weighing means that if the "big dog" is sick, the whole "market" gets the flu, regardless of the strength of the smaller stocks that are in the index (Wayman, 2007). A more equally weighted index would be more democratic and do a better job of capturing the impact of smaller stocks that may be rising but ignored due to scrutiny of larger companies.

Other Concerns

The stocks that are included on indexes are picked by committees who do their best to choose stocks that reflect the economy in a given year. Committees generally meet on a yearly basis to re-define the stocks to be included on the index. Because the stocks included in a given index change over time, one cannot assume that the index will reveal trading patterns of the same stocks over a long period of time. Another challenge for many is the knowledge that indexes are not as dynamic as the market itself. For this reason, some critics state that the indexes don't always reflect where growth will be in the market.

Stock Market Fluctuations

Market "Crashes" & their Causes

Stock market indexes are often quoted in the media as barometers of the overall health and vitality of the economy. Many stakeholders, including policy makers and individual investors pay close attention to daily fluctuations reported by the market indexes. There have been a number of documented "crashes" in the last several decades, and investors and indexes almost always tend to react to them in similar ways. The following is a timeline of "market crashes" and the related event that caused the reaction (Marcial, 2007):

• 1973 Oil Embargo
• 1987 Double-Digit Interest Scare
• 1998 Russian Debt Default
• 2000 Dotcom Bust
• 9/2001 Terrorist Attacks in US
• 2/2007 Chinese Market Trouble
• 8/2007 Sub-Prime Mortgage Scare
• 5/2010 "Flash Crash" High Frequency Trades Triggered by Single Large Sell
• 8/2011 Downgrading of U.S Credit Rating and European Sovereign Debt Crisis

Domestic Issues Affecting Stock Indexes

Stock market indexes are highly susceptible to pivotal events as indicated by the above list. Credit trouble in the US in 2007 has been a dominant theme throughout the year and has caused speculation that similar ills could spread into the global economy. The now-famous sub-prime mortgage troubles in the US are the type of issue that puts stock markets on high alert. In the US, stock indexes are affected by a number of domestic issues including (Steverman, 2007):

• Earning news-from retailers and manufacturing companies
• General economic data (consumer spending, employment)
• Interest rates from Federal Reserve (how much consumers and businesses can expect to pay when borrowing money).

Affects of Interest Rates on Stock Indexes

In the US, the Federal Reserve Open Market Committee (FOMC) assesses the risk to credit markets and ultimately recommends changes in interest rates. In the case of a credit crunch, an interest rate cut would help to pump money into the financial system. Bond markets are very sensitive to interest rate changes and also acutely aware of current credit woes. While stock indexes monitor equity markets and therefore are not directly tied to credit issues, stock indexes react to trouble in other areas of the financial markets and the economy as a whole (Coy, 2007). In a world where financial capital, debt and markets are globally interconnected, trouble in one area of the financial markets can easily cause reactions or "over-reactions" in other markets.

Some have described the global asset markets as "effectively shockproof" and point out that "every major developed and emerging market stock index is up on the year" (Wolf, 2007). This claim has been made despite the news of the sub-prime mortgage woes in the US, tightening global money, international trade tensions and even threats of a nuclear armed Iran. If history were to repeat itself, these issues would spell major trouble for US and international stock markets. Instead, there's "lots of global liquidity" coming from cheap and easy to access credit. Low global interest rates are freeing up money to fuel markets and money is also coming from other sources including: Hedge funds, private equity and leveraged buy-outs.

Arguments for New Index Development

The major US stock indices (Figure 1) have evolved over time to index the stocks in companies from different market segments. Within the 10 major US stock indices, technology, blue-chip, large cap and small cap companies are all represented by their own indexes. As industries and markets expand and markets become more subject to global influences and events, there is a growing move toward developing more specialized indexes to meet stakeholder needs. Investors simply may not be getting the information that they need from the indexes as they exist today.

"Maybe it's time for a new stock index -- one that will give a better picture than the current indexes do of how the average investor, or the average portfolio, is doing in the market at any point in time. That was the idea behind the first indexes. They were a shorthand way for investors to know roughly how their portfolios were doing" (Clowes, 2001).

There are many indexes to help track US stocks -- most are capitalization weighted and therefore are not really able to provide investors with a true idea of how a given portfolio is doing at a particular time. As a reminder, capitalization weighted indexes are stock indexes where each stock affects the index in relation to its market value. Because an index is capitalization weighted, "overheated" sectors or industries dominate the index. This concept is best explained using the following example:

"This [historic] example [post dotcom bust] shows- the impact of the tech stock sector on the S&P 500. The technology sector accounts for just 7% of the gross domestic product, but 36% of the S&P 500. Partly as a result of that weighting, in 1999 the S&P showed a total return of 21%, but the median money manager in the PIPER universe was up only 18.2%. This is because most of the gain in the S&P 500 was accounted for by just a few of the stocks in the index. Only about half of the S&P 500 stocks were up or flat in 1999. The others were down" (Clowes, 2001).

Many investors view cap-weighted indexes as showing distorted results in the markets. As we will discuss later in this article, some stakeholders have begun to create their own stock indexes using alternate criteria in an effort to help assess their portfolio performance.

Issues

Flaws in Market Capitalization

"When John Bogle, founder of the Vanguard Group, introduced the first retail index fund in 1976, he sparked a revolution in investing: Throw out the fund manager, keep costs low, and weight the stocks in the portfolio by their current market value. Today, $3 trillion in pensions and mutual funds are indexed" (Wagoner, 2007, ¶1).

Today, indexing by market capitalization has become the punching bag for many. "Critics of the S&P 500 and other widely used barometers say the indexes are inherently flawed because they are dominated by a handful of companies and because they must, by their very nature, add more shares of stocks that are rising and trim positions in stocks that are failing. Therefore, as investors move money in and out, managers of index funds are forced to buy stocks when they are overpriced and sell them when they are undervalued. If they don't trade, their funds no longer replicate the index they promise to track" (Landis, 2006).

A good example of the above scenario can be illustrated by what happened to the S&P index from March 2000 to Jan 2001. The S&P stock index dropped 25% while the average stock price rose 20%. Critics say that there has to be an explanation for such an overall drop in the index causing investors to lose "big" while prices of most individual stocks were actually rising.

"Like most indexes, the S&P 500 holds stocks in proportion to their market value (share price times the number of shares outstanding). So its holdings of the biggest company, ExxonMobil, with a market value of $415 billion as of mid August, are roughly 729 times greater than its holdings of number 500, Gateway, a $569 -- million firm" (Landis, 2006, ¶6).

"To own a representative sample of the market -- the purpose of indexing -- you need more shares of larger companies and fewer shares of smaller ones. Often, this results in index-fund managers buying more shares of companies as their prices rise, even if those shares are already expensive. At the same time, they must sell stocks that are out of favor even if they are well priced to buy. Rob Arnott, a California money manager and editor of Financial Analysts Journal tells investors the following about stocks in market-cap indexes. 'If you have money in a market weighted index, you can be absolutely assured that most of your money is in overvalued companies'" (Landis, 2006, ¶7).

Consider the following stats:

• At the end of 1999, the 10 biggest companies in the S&P 500 were valued at $3.1 trillion and made up 25% of the index total.
• In 2007, the 10 biggest companies in the S&P 500 were valued at $2.3 trillion and made up 20% of the index total.

Today, the S&P 500 is not as top heavy as it was during the dotcom boom, but the statistics from 1999 clearly show that "the stocks with the biggest run-ups have the biggest effect on the index" (Wagoner, 2007).

Alternatives to Market-Weight Indexing

Jeremy Siegel, a professor at the University of Pennsylvania's Wharton School has proposed an alternative to market-weight indexing. His company, WisdomTree, has developed two dozen funds that are indexed according to a company's earnings or dividends, rather than traditional market capitalization. Seigel is quick to point out that investors are the ones who suffer when indexes are over-weighted with large cap stocks. Seigel recounted a scenario that involved the Vanguard Index Fund and its indexing of Yahoo Stock in 1999. According to Seigel, the Vanguard Index was "forced" to buy overpriced shares of Yahoo due to the hype and run-up. Seigel himself was aware that his fund was investing heavily in expensive shares of Yahoo, but wasn't certain that other investors were aware of the situation. In any case, Seigel was looking for a "way out" and came up with the idea of an alternative index that would not overweight stocks such as Yahoo in his portfolio.

Active management of stock portfolios requires fund managers to analyze, build and manage stock purchases. Index funds are passively managed collections of stocks that represent a particular sector or class of assets. Index fund performance can beat active management of a portfolio in many cases and saves money, but many investors employ a strategy of indexing and active management to manage stock portfolios. Even with hundreds of stock index alternatives available, however, investors are calling for more choices than the traditional stock indexes. Stakeholders want access to real-time stock data; and they also are looking for indexes that offer insights into more diverse market segments.

Dividend-Weighted Indexes

Dividend weighted indexes have been proposed as an alternative to traditional capitalization-weighted indexes. Dividend weighted funds index according to company earnings and dividends. Dividend-weighted funds follow a value-oriented strategy.

Value-Weighted Indexes

Value indexes invest in undervalued stocks and are typically for more conservative investors. Value indexes are essentially the opposite of growth indexes. Growth stocks do better during a "bubble" when money pours out of value stocks and into growth stocks. At the bottom of the market, money moves out of growth indexes and back into value indexes.

Fundamental Indexes & Intelligent Indexes

Fundamental indexes are less vulnerable to market flux and hold stock in equal proportions. For example, one set of fundamental indexes weights holdings on sales, dividends, cash flow and book value. These measures help to place a firm's "footprint" in the economy-by using multiple statistics for indexing and weighting.

Intelligent indexes follow similar principals to the fundamentals indexes. They simply use different criteria to index a company's stock. One intelligent index claims to use 23 factors to construct its indexing algorithm. Factors include: Measures of value, price momentum, risk and timeliness -- all factors are intended to highlight companies "with the greatest investment merit" (Landis, 2006).

Exchange Traded Funds

Exchange Traded Funds (ETFs) are much like mutual funds (baskets of stocks that are bought and sold). ETFs are actually based on indexes which make them exchange traded index funds. There are nearly 700 ETF in existence today and only 2-3% index broad market funds. Criticism of ETFs is loud, but investors love them and they are gaining in popularity. ETFs track an index but can be traded like a stock at any time of the day -unlike their close relative the mutual fund. Purists cite the profusion of ETFs as insanity and the next gimmick in the market. Criticism centers around the lack of inclusion of broad-market funds in ETFs, but investors love their flexibility and access to non-traditional sectors. ETFs can track well known indexes (one closely matches the S&P index) while others index countries, regions, or commodities such as oil, gold or silver.

Private Placement -- Avoiding Stock Indexes

Private exchanges are gaining popularity as alternatives to selling company shares in public offerings. Instead of selling in traditional indexes, shares are sold to large investors who trade on secondary markets. One famous example of such a private or hybrid marketplace was launched by Goldman Sachs with the release of an electronic market called GS TrUE (Goldman Sachs Tradable Unregistered Equity). Goldman Sachs sold 15% of its Oaktree Capital Management for $880 million to a collection of hedge funds. Other heavyweight firms such as Merrill Lynch and Morgan Stanley are also investigating similar offerings. Private equity sales are known as 144A securities and the NASDAQ is planning to get in on the action with the creation of a new electronic portal trading system that will serve as a clearinghouse for 144A securities. The NASDAQ exchange is a competitor of the private exchanges, but sees an opportunity to complement its tracking of public markets with the new private exchange information.

In the case of the sale of Oaktree shares, Goldman Sachs specifically did not want to have pressure to show steady growth in a period of time their business market was considered to be "volatile." Other advantages to private or hybrid exchanges is for private equity and venture capital firms which includes the ability to cash out "equity" from companies that are not in fully public markets. While private exchanges are not expected to see a lot of active trading (many investors hold onto shares) there are some distinct advantages to trading in the private exchanges. Some of the benefits include: Relative stability in the market, avoidance of class action litigation and Sarbanes-Oxley compliance and less pressure to make quarterly earnings numbers. The avoidance of regulatory hurdles that must be met by companies trading in public exchanges will only make private exchanges more popular as companies take advantage of leveraging their own equity.

Conclusion

There are literally hundreds of stock indexes available to help investors and fund mangers track portfolio performance. The major US stock indexes such as the Dow Jones Industrial Average, S&P 500 and NASDAQ are broad market indexes that provide insight into the performance of many sectors of the US economy, and some would argue; the health of the nation's economy as a whole. Stock indexes are subject to fluctuations from a number of different factors and as such are closely watched by stakeholders and policy makers. Indexes such as the Russell 1000 track small cap companies and other "under-reported" sectors that are ignored by the larger stock indexes. While the major US indices offer coverage for a number of market sectors, investors are demanding more flexibility in indexes. In today's digital world where data is king and complex computations can be calculated with ease, there is an abundant supply of data with which to create and weight stock indexes. One may expect that savvy investors will continually seek out ways to slice and dice stock index data in the ongoing effort to "time and trade" the market.

Terms & Concepts

Broad-Based Index: An index that reflects the movement of the whole market.

Bear Market: A prolonged period during which market prices fall.

Bull Market: A period during which most stocks are increasing in value.

Equity Market: (Stock Market) A system that allows for the trading of company shares. This type of a system allows investors to take advantage of a company's success through stock price increases.

Exchange Traded Funds: Funds that track indexes but can be traded like stocks.

Float: The amount of shares that are publicly owned and available to be traded. The float number is calculated by subtracting the number of restricted shares from the total number of outstanding shares. Also known as "free float."

Growth Stock: Shares in a company whose earnings are predicted to increase at an above-average rate in relation to the market. Also known as a "glamour stock." A growth stock does not usually pay dividends because the company prefers to reinvest earnings in new capital projects. Growth stocks include most technology companies.

Hedge Fund: A fund generally used by wealthy entities outside of the purview of many rules and regulations that govern mutual funds. Since these funds are largely unregulated they allow for aggressive investement strategies that are unattainable to cannot be utilized in mutual funds. Examples include selling short, leverage, program trading, swaps, arbitrage, and derivatives.

Leveraged Buyout: (LBO): When a company is taken over using borrowed money. The new company's assets are used as collateral for the borrowed finances.

Major US Stock Indices: Shown in Figure 1: Dow Jones Industrial, Standard and Poor's, NASDAQ Composite, NASDAQ 100, Wilshire 5000, S&P Mid Cap, S&P Small Cap, Russell 3000, Russell 2000, Russell 1000.

Market Capitalization: Measure of the most recent stock price multiplied by number of oustanding shares (shares issued).

Open End Mutual Fund: A type of fund that allows investors to buy and sell shares directly. Share price is Net Asset Value (NAV).

Price Weighted Index: An index which includes constituents based on their price. In the case of a stock market index this suggests that stocks are included proportionately based on their stated prices.

Private Placement: The opposite of a public offering, a private placement is a direct private offering in which only a limited number of sophisticated investors are included.

Rule 144A: A rule that increases the liquidity of the securities affected (private placement in this context). Organizations can trade these formerly restricted securities between themselves which removes the restrictions that were previously imposed to protect the public.

Security: Something that represents financial value. Securities are generally organized into debt and equity securities including bonds and common stocks.

Value Stock: A stock that usually trades at a lower price proportionately to its fundamentals such as dividends, earnings, and sales, and is therefore deemed undervalued by a value investor.

Bibliography

Clowes, M. (2001). Time to update indexes. Pensions & Investments, 29(1), 10. Retrieved September 8, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=4025330&site=ehost-live

Coy, P. (2007, August 8). Sorry, Wall Street. Business Week Online, 13. Retrieved September 10, 2007, from EBSCO Online Database Academic Search Premier. http://search.ebscohost.com/login.aspx?direct=true&db=aph&AN=26137081&site=ehost-live

Gastineau, G. (2006) The best index for the thoughtful indexer. Dow Jones Indexes. Retrieved September 8, 2007, from http://www.djindexes.com/mdsidx/downloads/articles/BestIndex%5FGastineau.pdf

Hail the hybrids. (2007). Economist, 353(8541), 86. Retrieved September 8, 2007, from EBSCO Online Database Academic Search Premier. http://search.ebscohost.com/login.aspx?direct=true&db=aph&AN=25422476&site=ehost-live

He, L. T. (2013). Mean reversion of volatility around extreme stock returns: Evidence from U.S. stock indexes. International Journal of Business & Finance Research (IJBFR), 7(4), 91-101. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=86260857&site=ehost-live

Landis, D. (2006). Reinventing the INDEX. Kiplinger's Personal Finance, 60(10), 44-47. Retrieved September 8, 2007, from EBSCO Online Database Academic Search Premier. http://search.ebscohost.com/login.aspx?direct=true&db=aph&AN=22342500&site=ehost-live

Paudyn, B. (2013). Credit rating agencies and the sovereign debt crisis: Performing the politics of creditworthiness through risk and uncertainty. Review of International Political Economy, 20(4), 788-818. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=89683208&site=ehost-live

Steverman, B. (2007, June 29). Stocks flat after fed holds steady. Business Week Online, 14. Retrieved September 8, 2007, from EBSCO Online Database Academic Search Premier. http://search.ebscohost.com/login.aspx?direct=true&db=aph&AN=25760912&site=ehost-live

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Tan, A. (2013). Europe's surprising rebound. Kiplinger's Personal Finance, 67(10), 44. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=90056901&site=ehost-live

Waggoner, J. (2007, April 16). Great minds don't think alike about index funds. USA Today, 4B.

Waid, R. (2005). The Dow Jones Wilshire U.S. style indexes. Wilshire Associates, Inc. Retrieved September 8, 2007, from http://www.djindexes.com/mdsidx/downloads/DJW%5Fstyle%5Fwaid.pdf

Wayman, R. (2007) The ABCs of stock indexes. Investopedia. Retrieved September 10, 2007, from http://www.investopedia.com/articles/analyst/062502.asp

Wilshire 5000 index (2007) Street Authority.com. Retrieved September 10, 2007, from http://www.streetauthority.com/terms/index/wilshire5000.asp

Suggested Reading

Dodds, L. (2007). Brics and cement: Building in new markets. Global Investor, (203), 69-70. Retrieved September 8, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=25890584&site=ehost-live

Fortune, P. (1998, November/December).A primer on stock indexes. New England Economic Review, 25-40. Retrieved on September 8, 2007, from http://www.bos.frb.org/economic/neer/neer1998/neer698b.htm

Kosnett, J. (2007). Why stocks will keep going up. Kiplinger's Personal Finance, 61(7), 50-52. Retrieved September 10, 2007, from EBSCO Online Database Academic Search Premier. http://search.ebscohost.com/login.aspx?direct=true&db=aph&AN=25295468&site=ehost-live

Waggoner, J. (2007, August 3). How to find a fund that doesn't make your eye … USA Today, 8B.