A stock index is a basket of stocks which are put together in such a way to track a particular market, bond, currency, commodity asset or sector. For example, the FTSE 250 is an index that tracks the 101 to 350th largest public companies by market cap in the UK. The purpose of an index is quite simply to easily track the performance of a group of stocks.
An index is a group of stocks put in a basket based on an accepted methodology. This could be market capitalisation, sector or even stock price. E.g the FTSE100 are the top 100 public listed companies in the UK by market cap whilst the DOW JONES INDUSTRIAL AVERAGE Index is a price weighted index which consists of 30 public companies who are very significant on the New york stock exchange . These stocks are used to represent the general performance of the U.S economy. The stocks in the DOW JONES are so heavily traded that they represent ove r80% of the market volume.
You can invest in a stock index through an index fund which follows or tracks the index.
What is in an Index?
An index consists of various stocks which have been chosen based on an agreed methodology. E.g the NASDAQ is a collection of information technology stocks, this means if you buy a Nasdaq index you will essentially own stocks of the thousands of information technology companies its basket contains.
How Does an Index Work?
Indices are designed to track a particular market or asset. For example, the Gold and Precious Metals Index (XAU) consists of companies that mine gold and other precious metals. If you buy the stocks of the Precious metals index (XAU) you will get broad market exposure to the Gold mining market by essentially owning shares of all the stocks in the Precious metals index. The shares in the XAU are representative of the gold mining industry as a whole.
What Does Index-Weighting Mean?
Index-weighting is how the shares in an index basket are allocated; basically how the index is designed. For example, a price-weighted index has different amounts of shares for each stock based on price. A stock worth £20 would have 1 share, where a stock worth £5 would have 4 shares to make it equal to the £20 stock. This means more weight or more space in the basket is given to stocks which have higher prices.
There are other types of weighting, including:
- Even float adjusted indices
- Fundamentally weighted indices
- Market capitalisation weighted indices( this index weighting is based on the market cap of the shares outstanding per company)
- Revenue weighted indices
Advantages of investing in a stock index
Indexes are a great way to get broad market exposure to a particular market without needing to go through the expensive process of buying every single stock and paying a transaction fee on each transaction, it also avoids you having to do your own research on every single stock and continuously manage your stock allocation based on new information derived from research( this is because the index methodology is already in place and you are simply buying an index fund which tracks its price movement.
Disadvantages of investing in a stock index
Not all indices are black and white. While indices such as the FTSE 100 are relatively straightforward due to their black and white methodology others aren't. Imagine an emerging markets index where the methodology is on holding 10 stocks each of the top emerging economies. In this case, the definition of emerging might differ from investor to investor and if your views done align with those assigned to decide the stock methodology then you will miss out on markets which you consider inclusive of the index.
Index funds are also not very liquid, this means getting in at the right price and out at the right price might prove difficult.
In the same way, it is also hard to fill an order book with an index fund at the right price. In some cases you may not even get all the stocks in the index fund as prices fluctuate.
Are there any alternatives to stock index funds?
Yes, ETFs are much cheaper and much more straightforward to buy as they are already pre packaged in a basket and you simply have to buy shares of the ETF to get the same exposure as you would if you bought a stock market index fund.