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What is an Index?

Since the Dow Jones Industrial Average (DJIA) was first introduced in 1896, stock market indices have become ubiquitous. Virtually any daily news recap across the country would be incomplete

Since the Dow Jones Industrial Average (DJIA) was first introduced in 1896, stock market indices have become ubiquitous. Virtually any daily news recap across the country would be incomplete without the performance of the venerable DJIA, and usually the S&P 500 and Nasdaq Composite to boot.

Numbers go up? Times are good! Numbers go down? Times are bad! It’s simple. Of course, ask most people what those numbers actually represent and you’ll probably get little more than a confused look.

The basic principle behind any index is to compile information from a variety of different individual data points (usually the changes to the value of stocks) and combine it in a way that provides a broad overview of something (usually the stock market). Easy enough, right? Except that the methodology for selecting what goes in, what’s left out, and how it’s all added up makes for a dizzying array of options.

In the end, each index, like a snowflake, is unique. And before you consider how the performance of one or another index affects your portfolio or investment strategy, it’s important you know what kind of snowflake it is you’re looking at.

Rules-based vs. Criteria-based

At the core of the debate between active and passive portfolio management is the difference between selecting stocks and eschewing your own judgment to submit to the broader wisdom of the market. Why go to the trouble of handpicking stocks, or paying a fund manager to do it for you, when you can just invest in an index fund or ETF? If you can’t beat ‘em, join ‘em.

Except that this idea relies pretty heavily on the assumption that indices aren’t actively managed. And, in many cases, that’s just not true.

Take, for instance, the single most-traded ETF on the market, the SPDR S&P 500 Index ETF (SPY) . It tracks the S&P 500, widely perceived to be a bastion for passive management and the index to which most mutual funds are ultimately compared. But the 500 companies on the index are selected by committee, so “passive management,” in this case, just means fund managers outsourcing the active management to the good people at Standard & Poor's.

So what goes into picking which companies go in the S&P and which don’t? There’s a pretty specific thought process for adding companies, including four criteria involving the company’s size and trading volume, but it’s ultimately whoever the committee thinks should be included.

However, other indices, like those created by Russell Indexes, are strictly rules-based, using objectively-defined characteristics to define membership. The Russell 3000, for instance, is comprised of the 3,000 largest companies in the United States by market-cap (the collective market value of a company’s stock). The Russell 2000, one of the most trusted indices for American small-cap companies, is just the smallest 2,000 of those 3,000 companies.

In the end, the distinction is largely an academic one. Most investors probably don’t give a fig that their passively-managed S&P 500 ETF isn’t REALLY passively managed; it’s the 10 percent average annualized returns of the S&P that people care about, not the conceptual underpinnings of what defines passive management. And it’s not as if Standard & Poor's isn’t being forward about the nature of the selection process. It’s called the S&P 500, after all.

But that doesn’t mean that it makes sense investing in an index fund or ETF without a basic understanding of the selection process.

Price-weighted vs. Cap-weighted

Despite being the most-recognized stock index in America, the DJIA isn’t highly regarded among financial professionals. In fact, you would be hard-pressed to find a qualified fund manager who, pardon the pun, places any stock in it.

And while the fact that the DJIA only includes 30 companies and lacks a transparent methodology for selection are major reasons for this lack of credibility (the Wall Street Journal’s editorial board picks which lucky companies are included), perhaps the biggest gripe is that the index is price-weighted. This means that the weight assigned to each component is based on individual share prices, i.e. the effect a price movement has on the whole index is proportional to the price of its shares.

That wouldn’t necessarily strike an investing neophyte as being fundamentally flawed. But as anyone familiar with the stock market knows, share price can be a fairly arbitrary standard given that companies can create or buy back shares virtually at will, creating individual share prices that are largely independent of the characteristics of companies that investors actually care about.

For instance, a $100 billion company with 1 billion outstanding shares would have a smaller share price ($100 apiece) than a $10 billion company with 1 million outstanding shares ($10,000 apiece) despite the former being 10 times the value of the latter. Were both of those companies components of the DJIA, price fluctuations of the smaller company would have 100 times the impact on the index than those of the larger company.

Cap-weighted indices, like the S&P 500, determine each component’s portion of the total index based on the collective value of its stock. So, the fact that the first company from the previous example has a market value 10 times greater than the second company means that the first company’s price movements would have 10 times the effect on the movement of the whole index.

…And a Variety of Other Weighting Options, As Well

Cap weighting might make a lot more sense than price weighting, but it has its drawbacks as well. You might not place a lot of faith in the broader market to rationally price stocks, or you might be looking for an index that will paint a picture of something other than just market performance.

Some indices give equal weighting to each component, like the appropriately-named S&P 500 Equal Weight Index, so that each company’s performance affects the index equally regardless of size. This has the benefit of more closely resembling a personal portfolio, as a 10 percent increase in $1,000 worth of stock has the same benefit to you regardless of the size of the companies involved. Some also include designs like weighting based on performance or momentum. The SPECTRUM Large Cap U.S. Sector Momentum Index, for instance, shifts weight among the 10 S&P sectors to give more weight to the sectors with the strongest performance.

Still others weight based on fundamentals like book value or P/E ratio. In contrast to cap weighting, fundamental weighting can be especially appealing for investors who shudder at “overvalued” tech stocks that trade at massive earnings multiples.

The S&P 500 might give Google (GOOG) almost 70 percent more weight than Wal-Mart (WMT) (Google’s market cap is just under $410 billion while Wal-Mart’s is just over $240 billion), but an index weighted by net income would give Wal-Mart nearly 25 percent more weight than Google (full-year numbers for 2013 saw Wal-Mart clear just over $16 billion and Google just under $13 billion).

There are specific goals for each weighting methodology: a cap-weighted index is shooting for a broad overview of the value of the stock market, one weighted by net income seeks to paint a picture of corporate profits, and a price-weighted index is…well, mostly useless unless you’re really that interested in how individual share prices stack up. Either way, each index serves its own purpose, and being aware of that purpose is key to making it useful to you.

Free-Float Weighting

Another important question is whether an index is “float-adjusted” or not. Some indices, most notably the S&P 500, engage in what’s called “free-float weighting,” which involves only considering those shares available on the open market.

Basically, a float is how much stock a company has issued, but its free float is the stock that’s actually available on the free market. Some portion of a company’s shares aren’t really for sale as they’re owned by entities with an interest in strategic control of voting shares, like officers and directors or venture capital firms. By removing those shares that aren’t really available on the open market from consideration, it paints a clearer picture of the stock market as it exists for most investors.

So, if the company from the earlier example with a $10 billion market cap has 60 percent of its shares controlled by company officers, the S&P would effectively weight it like a $4 billion market company (40 percent of its total market cap).

Not Just Stocks

Of course, to this point, we’ve only really discussed indices that track stocks, but some notable indices actually gauge other asset classes.

There are a variety of different bond indices that track the yields, prices, and value of the bond market. The Chicago Board Options Exchange Market Volatility Index, better known as the VIX, uses the size of options contracts to judge how much market volatility traders expect to see over the next month. The Baltic Dry Index (BDI) tracks the cost of shipping raw materials over 23 different routes on a timecharter basis and is an indispensable tool to those investing in shipping companies. And the London Metals Exchange Index (LMEX) tracks the prices of six non-ferrous metals and produces a single index based on their shifting values.

The Market Index and You

With so many different markets and sub-markets out there, it can be really difficult to get any sense of what’s going on in the global economy without using indices. They’ve become essential, on some level, to understanding the world we live in.

But not all indices are created the same. They’re intentionally designed to show different things about different things, and it’s a wise investor who takes the time to do the research necessary to really understand what their favorite index really means.

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