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18th June 2019 | Mateusz Groszek | Portfolio Fundamental Analyst

What are indexes and how they work?

Today we will explain the definition and the role of indexes in the financial markets. To keep it simple, we could say that an index is an indicator, it measures something. In the financial world the indexes measure the stock market, bond market, commodity market, alternative investment market or real estate market.

Usually, the indexes measure the power of a similar group of instruments, like the S&P 500 index shows the shape of the United States blue chip companies. But there is no restriction, the index provider could mix asset classes and markets. There is one thing that investors should know: there is no possibility to invest directly in an index. 

Methodology Construction

Every index could have different characteristics and could include different asset classes. Furthermore, every provider could have a different specific market definition. That’s why the index provider facilitates the prospectus for every index. Below are the factors that define the index:

  • Description – in the description, the index providers give the main information about the index like country, how many companies are included and what is the main objective of the index.  
  • Universe – it describes the main components of the index. For example, the S&P 500 index includes the biggest 500 companies only from the United States.
  • Eligibility Market Cap – usually it defines the minimum market cap of companies that are eligible to be include in the index
  • Public Float – this defines the minimum percentage shares outstanding that must be available for trading
  • Weighting method – after the index universe it is one of the most important factors to consider. It gives the information about the way of calculating the weight in the index of each component. The most well-known weighting schemes are:
    • Price-weighted index – it’s simply the sum of all the security prices divided by the total number of constituents. It is not so popular as in the past, because the security price does not inform about the true market value of the instrument. 
    • Market-capitalization weighted index – weight securities by market value. Nowadays the most indexes are market-capitalization. It means that the biggest company will have the highest weight in the index. 
    • Risk-weighted index – this is a less popular index weighted method than the two previously explained. It weights the security, for example, by variance, historical volatility or Value at Risk. 
    • Fundamentally-weighted index – weight constituents based on their financial health. The better shape companies will have a higher weight within the index. 
  • Rebalancing frequency – this criterion defines the date of the index rebalancing. Some securities will be replaced in the indexes. 
  • Calculation currencies – describes the currency of the index. For example, the most popular index in the world – the S&P 500 is calculated and presented in 11 currencies but includes only companies from the USA. Above criterion are for equity indexes. In the case of bond indexes there are also maturity focus. The indexes can measure broad markets as well specific maturities like 1-3 years.

Index role in financial markets

Institutional fund managers usually use benchmarks as a proxy for fund performance. Every manager tries to beat the benchmark performance. The manager could follow the benchmark or could deviate from that. 

In the past, the most popular funds were actively managed, which means that the manager tried to beat the benchmark. 

The indexes itself also use as a benchmark for Exchange-Traded fund which follows the index. Those type of instruments follow strictly the benchmark return; they are not trying to beat the benchmark.

Real World Example indexes

The most familiar indexes in the world are: 

  • S&P 500
  • Dow Jones Industrial Average
  • Nasdaq Composite
  • S&P 100
  • Russell 1000
  • S&P 400
  • Russell Mid-Cap
  • Russell 2000
  • S&P 600
  • U.S. Aggregate Bond Market
  • Global Aggregate Bond Market

All the above indexes are used mainly as a benchmark and used to track the United State assets. In the rest of the world, we will find a more specific index like following the only specific sector. To sum up, every benchmark provider shares with investors the white paper or prospectus of the index. Before we will be able to tell anything about any index, we should be familiar with these documents.

Golden Sand Bank ("Bank") exercised due diligence to ensure that the information contained in this publication was not incorrect or untrue as at the date of publication.

All Investment products are at risk, as their value can go down as well as up. The tax treatment of your investment will depend on your individual circumstances and may change in the future. If you are unsure about whether investing is right for you, please seek financial advice. This publication is not an investment recommendation or investment advice in connection with any services provided by the Bank to the Client.

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