WHAT IS AN INDEX?

• In finance, an index reflects the price of a collection of stocks, bonds, commodities, or other assets.
• Indexes such as the S&P 500 are used to measure how baskets of certain assets are performing, as well as provide benchmarks for how professional investors are doing vs. “the market.”
• Index funds, including mutual funds and exchange traded funds (ETFs) are simple, low-cost ways to gain exposure to markets.

An index is an indicator, sign, or way to measure something. In financial terms, an index reflects the price of a collection of stocks, bonds, commodities, or other assets – or even entire markets. The Dow Jones Industrial Average (DJIA), for example, is an index commonly cited in the media and by some politicians as a reference for how “the market” is doing.

Charles Dow created what is now the DJIA in 1896, the first major market index.¹ In the decades since, thousands of indexes have been launched to track the performance of every major financial asset class, giving investors countless ways to measure market performance, as well as providing the blueprint for modern portfolio theory.

Indexes are important for the financial markets because they are used to measure how baskets of certain assets are performing, as well as provide benchmarks for how professional investors are doing vs. “the market” as well as their peers. The S&P 500 is a common benchmark for Wall Street professionals.

Great as they may be, indexes are really for illustrative purposes only. Indexes are unmanaged and one cannot invest directly in an index. In the 1970s, index funds were launched, enabling investors to access various indices and sparking a revolution in the financial markets. More on index investing follows, but first a primer on some popular indexes and an analysis of the differences between two of the most well-known stock indices: The Dow Jones Industrial Average and the S&P 500.

Examples of an Index: the DJIA and S&P 500

The main differences between the DJIA and S&P 500 are how each index is constructed, and how the performance of individual members affects the respective index as a whole. Here’s a breakdown:

The Dow Jones Industrial Average The Dow Jones Industrial Average is an index designed to measure the performance of 30 of the largest U.S. corporations across a wide range of industries. Historically, Dow 30 members are headquartered in the U.S. and generate a significant amount of revenue from within the U.S.

Often referred to as “the Dow”, the DJIA’s constituents are selected by a committee composed of three representatives of S&P Dow Jones Indices and two representatives of The Wall Street Journal.²

“While stock selection is not governed by quantitative rules, a stock typically is added [to the Dow 30] only if the company has an excellent reputation, demonstrates sustained growth and is of interest to a large number of investors,” according to S&P Global Indices, which owns and manages the venerable index.

Changes to the Dow 30 can occur anytime on an as-needed basis but there is no regularly scheduled rebalancing for the Dow, as is common with many other indexes. The committee behind the Dow aims to change the index very rarely, to preserve continuity. Typically, changes to the Dow are only made in response to significant corporate developments such as mergers or a prolonged drop in a firm’s financial performance.³

Notably, the Dow 30 is a price-weighted index, meaning the share price of a company’s stock is a consideration for inclusion (or removal) from the index. And because it is a price-weighted index, Dow members with higher-priced stocks have a greater influence on the index itself vs. those with lower prices. As a result, the committee behind the index aims to ensure the highest-priced stock in the index has a price no more than 10 times that of the lowest.

The price of the Dow Jones Industrial Average that’s typically cited is calculated by adding the price of all 30 stocks in the index, and then dividing the total by the so-called Dow divisor. Currently 0.1517, the Dow Divisor is periodically adjusted to reflect dividend payments, stock splits and other corporate actions.⁴

The S&P 500: The S&P 500 is an index comprised of the 500 largest publicly traded U.S. companies by market capitalization. Market capitalization, or “market cap”, is the dollar value of a company’s total outstanding share of public stock, also known as its “float”. If, for example, a company has 100 million shares of outstanding public stock trading at $100 per share, its market cap would be $1 trillion.

Market capitalization is often used as a way to measure a company’s size, and as a way to differentiate between and among companies. For instance, companies are typically categorized as being large-, mid- or small-cap based on their market capitalization.

Because it is directly tied to its share price, a company’s market cap typically fluctuates daily, often on an intraday basis, whenever the stock market is open for trading. In addition to trading activity, a company’s market cap can be most directly affected by changes to the total number of shares outstanding, which can rise or fall when a company executes a stock split or share buyback program.

As noted above, the Dow Jones Industrial Average is often cited in the press and conventionally seen as a barometer of the health of U.S. corporations and the American economy itself. But the S&P 500 is the most commonly cited index among professional investors and is arguably the world’s most important equity index, based on the following:

• The 500 represents approximately 50% of global equity market capitalization.⁵
• The ecosystem of products directly linked to the S&P 500 – including options, futures and exchange-traded products (ETPs) -- generated $224 trillion of trading volume in 2023.⁶
• There’s approximately $3.5 trillion of assets under management in index mutual funds and ETFs tracking the S&P 500.⁷

The S&P 500 is overseen by an index committee which constructs the index by selecting stocks that meet the index’s eligibility requirements, which include:

• Market cap: Companies must have a market cap of at least $18 billion.
• Public float: At least 10% of a company’s outstanding common stock must be available to trade publicly.
• Financial viability: To be added to the S&P 500, a company must have reported positive earnings in the most recent quarter, as well as over the prior four quarters (in sum).
• Liquidity: A company’s stock needs to have traded a minimum of 250,000 shares in the six months prior to be considered eligible for inclusion.

From among those companies that meet the eligibility requirements, the index committee then chooses 500 companies while aiming to maintain a balance of companies from among each of the 11 sectors in the S&P 500.

The sectors – information technology, financials, healthcare, consumer discretionary, consumer services, industrials, energy, consumer staples, real estate, utilities, and materials -- are determined via the Global Industry Classification Standard (GICS). GICS is “a four-tiered, hierarchical industry classification system” that subdivides the 11 sectors into industry groups, industries and sub-industries.⁸ For example, capital goods is an industry group in the industrials sector and aerospace & defense is a sub-industry within it.

Using the GICS, the S&P 500 index committee chooses how many companies from each sector are added to the index. Those so-called sector weightings fluctuate over time based on the performance of individual companies from each sector. For example, the information technology sector currently has an approximately 30% weighting in the S&P 500, up from less-than 15% in 2014 owing to the strong stock performance of IT constituents in the past decade.⁹

Changes to the S&P 500 can be made at any time, typically in response to major corporate actions like mergers, bankruptcies or significant market development. If a stock has been delisted or the company declares bankruptcy, a replacement is selected from a list of eligible securities.¹⁰

 

The S&P 500 is reconstituted annually, after the close of the third Friday in June. Share counts are updated quarterly and reflected in the index weights. Constituents that are dropped from the S&P 500 are not replaced until the next annual reconstitution.¹¹

As with the Dow, the S&P 500 is calculated using a divisor which is adjusted regularly to address changes such as additions or deletions to the index. Unlike the Dow, the S&P 500’s numerator is the total market value of its components rather than the sum of their prices.¹²

The S&P 500’s divisor is currently 8395.39.¹³

Index funds are simple, low-cost ways to gain exposure to markets. They’re most commonly available as mutual funds and exchange traded funds (ETFs). While stocks, bonds, commodities and real estate have been around for centuries, index funds are relatively new on the scene. Since launching in the early 1970s, index funds have revolutionized how investors access the financial markets.

Index fund providers aim to deliver market exposures that are investable, precise and consistent.  At iShares, we measure the performance of our index ETFs by focusing on two key elements:  Precision and market quality.

Precision is a measure of how well funds replicate the performance of an underlying index, and their ability to do so consistently over time. Market quality refers to the ability of our ETFs to offer liquidity, price discovery, and efficient access under varying market conditions.

The precision of an index fund can be assessed by the following:

• Tracking difference, which measures the difference between a fund’s return and that of its benchmark index.
• Tracking volatility, which measures the standard deviation (i.e., the volatility) of an investment’s tracking difference month-over-month.
• Rebalance efficiency, which measures how effectively the fund delivers index outcomes. Most index providers rebalance their indexes regularly, adding or removing securities or changing the weights of existing index constituents. As a result, index fund managers must reconfigure portfolio holdings to match the rebalanced index so they can continue to achieve their index-tracking objectives.

Market quality refers to the ability of ETFs to offer liquidity, price discovery, and efficient access to markets under varying conditions. As with precision, various elements go into an ETF’s market quality, including:

• Trading dynamics such as average daily volume and bid-ask spread are common measures of market quality. The bid-ask spread is the difference between the price an investor is willing to buy (the bid) and the price at which its owner is willing to sell (the ask). High and/or rising average daily volumes, and tight bid-ask spreads typically indicate strong market quality.
• Premium-Discount behavior refers to whether an ETF’s price per share is above, below or equal to the net asset value (NAV) of its underlying holdings. Multiple factors go into evaluating premium/discount behavior, including market conditions and the maturity of the underlying market. For example, an ETF trading at a price per share close to its NAV can reflect primary market efficiency in stable or liquid markets. Meanwhile, the appearance of premiums or discounts amid heightened volatility illustrates how ETF prices provide price discovery. Both are indicators of market quality.
• Underlying market impact is measured by the ratio of an ETF’s secondary market activity to its primary market activity (the “STP ratio”). A higher STP ratio suggests the ETF’s trading is being efficiently processed with minimal market impact, meaning shares of underlying securities do not need to be bought or sold to adjust for changes in investor demand. Imputed flow, the measure of how ETF inflows and outflows influence the trading of individual stocks is another way to measure market impact.

Our performance framework can help investors understand how ETFs track their indexes and deliver market quality in all market conditions. It’s also a good reminder that there’s nothing passive about index fund management.