Understanding stock market indexes: S&P 500, Nasdaq, FTSE, Nifty and more

When the news says "the market rose today", it usually refers to an index. An index is a list of shares, combined into a single number that shows how that group is performing. Indexes are used as headlines, as benchmarks and as the basis of countless investment funds. This article explains how they are built, why the method of weighting matters, how some of the best-known indexes differ, and how to use them well.

What an index is

An index tracks a chosen set of securities. Each index has rules about which companies are included, how they are weighted, and how often the list is updated. The index level is a number that rises and falls with the value of the group. The level itself, such as 5,000 or 25,000, has no meaning in isolation. What matters is the percentage change.

Why the weighting method matters

Three common methods give different results.

• Market-cap weighting. Companies are weighted by their market value, which is the share price times the number of shares. Larger companies have a bigger influence. Most major indexes use this method, usually adjusted for the shares that are actually available to trade, called free float.
• Price weighting. Companies are weighted by their share price. A share priced at 200 has ten times the influence of one priced at 20, regardless of the size of the company.
• Equal weighting. Every company has the same weight, so smaller companies have a larger influence than in a market-cap index. The index needs periodic rebalancing to keep weights equal.

A simple example. Company A has a share price of 200 and a market value of 100 billion. Company B has a share price of 20 and a market value of 400 billion. In a price-weighted index, A has about 91% of the weight (200 out of 220). In a market-cap-weighted index, B has 80% (400 out of 500). The same two companies produce very different indexes.

Price index versus total return index

A price index tracks only share prices. A total return index also assumes that dividends are reinvested. Over long periods, the difference can be large. When comparing your portfolio with an index, use the total return version, so that you compare like with like.

Some well-known examples

• S&P 500: about 500 large US companies, market-cap weighted, selected by a committee on size, liquidity and profitability rules.
• Dow Jones Industrial Average: 30 large US companies, price weighted, which is unusual today.
• Nasdaq Composite: companies listed on the Nasdaq exchange, with a heavy weighting toward technology.
• FTSE 100: the 100 largest companies listed in London. Many earn most of their income abroad, so it reflects the global economy more than the UK economy.
• Nifty 50: large Indian companies listed on the National Stock Exchange, with a large weight in financial services.
• MSCI World: large and mid-sized companies across developed markets.
• MSCI Emerging Markets: large and mid-sized companies in emerging economies.

Concentration

Because most indexes are cap-weighted, a few very large companies can account for a significant share of an index. When those companies perform strongly, the index rises even if the average company does not. When they stumble, the index can fall sharply. Check an index's top holdings and sector weights, to see what you are really exposed to. An index of 500 companies is not necessarily as diversified as it sounds.

How indexes change

Indexes are reviewed from time to time. Companies are added when they grow or meet criteria, and removed when they shrink, merge or are delisted. This means an index's past performance reflects survivors and companies that were promoted, and it is not a fixed group of companies. Index providers publish their methodology, and it is worth reading.

How to use an index

• As a benchmark. Compare your portfolio, or a fund, against a relevant index to see whether your choices have added value. Choose an index that matches your holdings, such as large US shares or global shares, and compare total returns over the same period.
• As the basis for investing. Index funds and ETFs let you hold a whole index in a single, low-cost product. You get market returns minus fees, without choosing individual companies.
• As a gauge of the market. Indexes summarise sentiment and conditions, but one index does not show the whole market.

Cautions

• No index is "the market". Each covers a particular slice.
• An index is quoted in a currency, which affects comparisons across countries.
• You cannot invest directly in an index. You invest in a fund that tracks it, which has costs and may differ slightly from the index.
• Past index performance does not predict the future.

Common mistakes

• Comparing a global portfolio with a single-country index.
• Comparing total returns with a price-only index.
• Assuming that a large number of holdings means diversification.
• Ignoring the currency of the index.
• Treating the index level as meaningful on its own.

A short checklist

• I know how my benchmark is weighted and what it contains.
• I use total return figures for comparison.
• I have looked at its top holdings and sectors.
• The index matches what I actually own.

Indexes are tools for measuring and for investing. Understanding how they are built helps you use them well and avoid being misled by headlines.