What is a market index?
A market index is a hypothetical share portfolio representing a specific segment of the financial market. The calculation of the index value comes from the prices of the shares it contains, the presence of which is adjusted using the weighting method. Most indexes have values based on market capitalization weighting. In these cases, the weighting of each company within the index is established based on its size. Therefore, bigger companies have a bigger weighting within the index.
Generally speaking, investors follow several different market indexes to assess the stock market movement. The three most popular market indexes used to keep track of the performance of the US market are the Dow Jones, the S&P 500 and the Nasdaq Composite. In the bond market, Bloomberg Barclays is a leading supplier of market indexes with the U.S. Aggregate Bond Market index. Investors cannot invest directly in an index, which means that these portfolios are widely used as benchmarks or to develop index funds.
How a market index works
Market indexes measure the value of a portfolio of investment holdings with specific market characteristics. Every index has its own methodology, which is calculated and managed by the index supplier. Generally, index methodologies are weighted by price or market capitalization. A wide range of investors uses market indexes to manage their investment portfolios. In the capital management sector, funds use market indexes as benchmarks for performance comparison or as a base for the creation of new portfolios.
The mathematical weighted average is the most widely used methodology for calculated the value of a market exit. It uses a weighted valuation of the overall portfolio to reach a valuation. As a result, price-weighted indexes are more influenced by variations in shares with higher prices, market-cap weighted indexes are more influences by variations in bigger holdings, while other weightings are influenced by different factors, according to the weighting criteria.
Indexes as benchmarks
Given that indexes are hypothetical share portfolios, they play the role of benchmarks in all financial markets. As we have already mentioned, the Dow Jones Industrial Average, S&P 500 and Nasdaq Composite indexes are three popular ones in the USA. The Dow Jones Industrial Average includes the 30 biggest holdings in the USA based on market capitalization, while the S&P 500 includes the 500 biggest holdings and the Nasdaq Composite includes all shares listed on the Nasdaq. The fact that they include some of the most significant shareholdings in the USA means that the indexes offer a good representation of the overall US investment market.
Other indexes have more specific characteristics with a more restricted market focus. They can represent micro-sectors or a geographical market segment, as is the case for indexes depicting emerging markets or shares in the UK and Europe, such as the FTSE 100.
The benchmark of each fund is set out in its prospectus to ensure transparency for investors. Fund benchmarks can also be used to assess the performance of fund managers.
Institutional fund managers also use indexes as the basis for the creation of index funds. Individual investors cannot invest in an index without purchasing every one of the individual holdings, which is generally too expensive from a commercial perspective. As a result, index funds are offered as a low-cost way of investing in a complete index portfolio. Index funds replicate the chosen index. Some of the management and negotiation costs are still included in the fund expense ratio, but costs are much lower than commission on an actively managed fund.
Main market indexes
The following are some of the main market indexes:
- 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
*We recommend that you consult with your bank or a financial advisor before making any investments. This article is mainly focused on the Italian market and on other leading markets. We advise that readers check the data and regulations pertaining to their countries.