Market Indexes Explained: Meaning, Construction, Types & Importance
Market Index is a common term that you hear every day. Whether on T.V., blogs, or social media, you are likely to have heard or seen this phrase. Similarly, in many discussion topics, reporters, fund managers, or investors often mention words like “S&P 500” or “Dow Jones.” Consequently, many people tend to wonder, what are these things? Let’s understand what “these things” are.
What is a Market Index?
Generally, an index is a measure of something over time. In the financial market, a market index measures how good or bad securities or financial instruments are perfoming in their respective markets. Simply put, a market index tracks the rise and fall of stocks, bonds, financial derivatives, and trading commodities.
A number of these under each category are selected to form a basket of holdings. Each item is weighted to create a certain percentage of the overall holdings index. The aggregate index is then used to represent the performance of a market segment, specific asset class, or industry. What does this mean?
Take an example of the S&P 500 index. This stock index tracks the performance of about 500 of the biggest companies listed on the New York Exchange Market. And since most U.S. companies are included in this measure, a change in the index can tell us how the U.S. equity market is moving. Likewise, a bond index will demonstrate how the bond market moves, whereas an industry index will show how a particular industry moves.
In the stock market, a rise in the index level suggests many investors are buying shares under the index component rather than selling. As a result, the stock prices are going up. On the other hand, if the index is falling, many investors are selling stocks rather than buying. The same thing happens in bond and commodities markets. If bond indexes are rising, many investors are buying rather than selling. If falling, then many investors are pulling out of the market.
Consequently, the most important thing for investors is the movement of the indexes. Specifically, they are keen on how much an index gained or lost compared to the previous period. By evaluating these changes, they can analyze the health of a market or industry.
Which are the Types and Examples of Market Indexes?
Institutions create indexes to analyze assets, sectors, regions, and growth. Major indexes include stock, bond, and currency indexes. Indexes are further subdivided into growth, value, sector, and industry indexes.
The stock indexes are the most widely known and used class of indexes. These indexes track the performance of stocks in the stock exchange market. Some major indexes under the stock category include S&P 500 and Dow Jones Industrial Average in the U.S. In the U.K., major stock indexes include the FTSE 100 Index, FTSE 250 Index, and FTSE All-share index. In the Asian Market, Nifty 50 and S&P Asia 50 are the most popular indexes.
Other than stock indexes, market indexes also include:
1. Bond indexes: Examples include the Bloomberg US Aggregate Bond Index
2. Currency Indexes: Examples include UK Pound Sterling Index and U.S. Dollar Index in the U.K.
3. Commodities Indexes: Examples include Asia-Pacific Commodities Index and The Afreximbank African Commodity Index.
Since many indexes exist, it is crucial to understand what each index measures. For example, if you are interested in bond performance in the U.S., you would use an index like Bloomberg Bond Index that tracks bonds. In contrast, if you are interested in stocks in the U.S. pharmaceutical sector, you will probably use an industry-specific index such as S&P BSE Healthcare.
Why are Market Indexes Important?
- Indicators of Market Health and Economic Trends
Indexes provide a clear picture of how any market is moving. Consequently, we can understand the health of a country’s economy.
An index containing many publicly traded companies can hint at current and probably future economic trend . National Indexes such as S & P 500 or the Dow Jones offer valuable information on the overall health of the financial market in the U.S. If these indexes are falling for a considerable time, then the stock market and hence the overall economy is underperforming. The same can be said of China’s or Britain’s economies if their national indexes are persistently declining.
We will likely have a bear market if an economy is heading or in recession. In such a situation, falling stocks or commodities are due to, but are not limited to, dropping investors’ confidence and declining investments. On the other hand, substantial growth by many companies, characterized by rising investments, increased consumption, and spending, pushes the market stock prices up.
Typically, the stock and bonds markets will move in the same direction as the economy in the long run. If the domestic or regional economies are doing well, financial markets will be healthy and vice versa.
2. Benchmarks for Investments
Investors in the stock markets use indexes to check how well or poorly they are managing their portfolios. Institutional and individual investors often measure the returns on their portfolios against returns on the indexes. If their portfolio returns are greater than the returns on an index, then they are outperforming the market. The same cannot be said if the returns are below those of the indexes.
Most managers or investors also use these market indexes to evaluate how the market is moving. After taking note of these movements, they will choose their strategy method in a process called index investing.
3. Basis for Index Investing
Index investing is one of the popular ways of investing and managing a portfolio of assets. Under this investment strategy, the fund manager selects a portfolio of securities that resemble the securitIes on an index. The chosen items mirror the composition of a specific index.
This form of passive investing is much easier than active investing. For the latter, the fund managers must analyze hundreds of securities and settle on a few that seem as suitable investments. Besides, the fund managers must choose the right time to invest or pull out of the investment. All these activities translate to high management fees and transaction costs.
However, with index investing, all these costs are minimized. You only need to track the holdings in an underlying index and invest in them. Besides, you get to diversify your portfolio. How, then, do you invest in indexes?
You cannot invest in indexes directly. Nevertheless, you can use index funds and ETFs to achieve the same goal. Index funds and ETFs mimic the securities or financial derivatives included in popular indexes such as S&P 500 and Nasdaq composites. By choosing assets on indexes for your portfolio, you also mirror their returns.
Even though index funds and ETFs are similar in most elements, they share a few differences. It is essential to understand them before choosing which instrument to invest in.
Final Thoughts
Market indexes are important for any country, region, sector, or industry. Not only do they tell us how certain companies are doing, but they also reveal how healthy a market or economy is. As a result, market indexes are indispensable investment tools of the modern world.
