I field a lot of questions about indexes. What’s the S&P 500? How is it different from the Dow Jones? What is the Russell 2000 and why does it regularly outperform its peers? I think this is important information for the average investor to know. I had one client call me on a day when the Dow Jones was down over 100 points to ask how poorly his stocks were performing. I explained that while the market averages were trading down that day, his individual portfolio was actually up. How is this possible? Well, the Dow Jones Industrial Average only represents 30 companies out of thousands which are publicly traded. On a separate note, indexes are also growing in popularity because of the explosion of exchange-traded funds–investments which track indexes. Let’s talk more about indexes and what you should know.*
Ever since the creation of the Dow Jones Industrial Average in 1896, new technologies have made it possible to continuously create new indexes which capture the performance of more specific slices of the stock market. While the Dow came first, it only displays the average performance of 30 massively popular companies. The broader market index which I prefer to check is the S&P 500.
The S&P 500 has a committee which chooses the index participants based on a variety of criteria. They try to keep the index broad and full of the largest companies representing a diverse cross-section of the economy. Traditionally, the index is comprised of mainly US companies. However, you’ll find some foreign companies which have been in the index for a while and thus have remained part of it.
The construction of an index, especially one with the popularity of the S&P 500 is particularly important because of how many mutual funds and other investments try to mimic the holdings of the index. You can think of index participation as “prestigious” as it rewards the companies with increased trading of its underlying holdings. Because of this desirable inclusion, lots of discussion takes place about how exactly the index construction should work. Currently, we use a “market-cap” weighted system. This simply means that each stock’s value within the index is based on their number of shares outstanding mutiplied by their current stock price. This obviously works in favor of giant companies such as Microsoft, General Electric, and Bank of America. Critics might point out that a market-cap system such as the S&P 500 will not fairly represent smaller companies within the index. This is because they may have fewer shares outstanding at presumably lower prices. Supporters of the market-cap system will simply point out the accuracy inherent in the market-cap system. If Microsoft, General Electric, and Bank of America are some of the largest companies in the United States, why not reflect them as such within the index?
Besides the S&P 500 and the Dow Jones Industrial Average, here are a few other indexes I think are important to know about and what they follow:
The Nasdaq Composite: All of the stocks listed on the NASDAQ stock market. The NASDAQ is an all-electroic market where trading takes place through computer networks rather than central trading locations (such as the NYSE). The NASDAQ is also known for how many technology and growth-oriented companies are listed on it. It’s not impossible or unusual for the Dow Jones or S&P 500 to trade up and the NASDAQ trade down on the same day (or vice versa). The NASDAQ index is trading at approximately 2507 at the time I’m writing this article. It has traded over 4600 during the “tech bubble” of year 2000.
Russell 2000: A listing of 2000 small-cap stocks. “Small-cap” indicates smaller companies with market-caps ranging from a few hundred million to a few billion. For comparative purposes, consider that Microsoft has a market-cap of roughly $280 billion. So these are not small cmpanies like Mom and Dad’s candy store. But they’re small relative to the enormous amount of wealth present in the US stock market.
The NYSE Composite: This index covers common stocks listed on the New York Stock Exchange. It includes ADRs (foreign stocks trading on US exchanges) and REITs (companies which manage real estate using shareholder funds). The index covers over 2,000 stocks. It includes a fairly diverse group of stocks across ten separate industries.
The Wilshire 5000: The Wilshire is the broadest index we have for the US stock market. It includes 5000 stocks with various capitalizations and from various sectors of the market. Some people think this index is “too broad.”
FTSE 100 (sounds like foot-zee): The 100 largest stocks (by market cap) listed on the London Stock Exchange.
CAC 40: This is a reference of the French stock makret–the 40 largest capitalized stocks on the Paris Bourse.
DAX: 30 major German stocks trading on the Frankfurt exchange.
Nikkei 225: This is the stock market index for the Toyko Exchange. It’s generally the most popular watched stock index of the Asian countries.
As we mentioned above, there have been a record number of indexes constructed in the past few years. There are many explanations for this, some of which revert back to the “active” vs. “passive” argument about investing. Is it better to simply buy a fund based on an index? Or is it better to buy an actively managed fund which attempts to beat the index. Generally index investments have lower costs than actively managed funds. Intellectuals such as Jeremy Siegel have suggested that index investing may be superior because active managers, over long periods of time, haven’t found success in beating their benchmarks. Siegel has suggested that high costs and fees have accounted for much of this underperformance. Indexes today range from the stuff mentioned above, to sector indexes (biotechnology, insurance, retail, software, semiconductors) to “green” indexes, to basically anything else you can imagine.
Questions? Comments? E-mail me.
Russell Bailyn
Premier Financial Advisors
14 E. 60th Street, #402
New York, NY 10022
(212)752-4343 *31
rbailyn@premieradvisors.net
Securities and certain investment advisory services offered through: First Allied Securities, Inc., a registered Broker/Dealer. Member: NASD/SIPC. Premier Financial Advisors, Inc. is a Registered Investment Advisor. First Allied Securities & Premier Financial Advisors are not affiliated entities.
*There are limitations in using financial indeces described above for comparison purposes because the funds may have different volatility, credit & other material characteristics. Indices are unmanaged and may not be available for direct investment.