Constructing & Decoding an Index

An index doesn’t just happen. It’s created by an index provider to meet one or more objectives, such as providing a benchmark, serving as the basis of a financial product, or both. Having identified the
index’s purpose and determined that it can be calculated, the provider can begin to develop its methodology, which involves: Defining the index’s focus and scope. Identifying the securities that will form its portfolio. Determining how the index will be weighted. Setting the criteria for changing the components of the index, how those changes will be made and deciding how it will be calculated.

If you’re investing in an index-based product, you need to know how the underlying index is weighted and what impact that weighting system is likely to have on performance. Most equity indexes are market-cap weighted. These indexes are sometimes described as providing the most accurate reading of what the market is doing. That’s because the largest companies with the most shareholders tend to have a greater impact on market return than smaller companies that are less widely held. However, there can be a disconnect between index results and the economy if the robust performance of a few large companies drives the index up while most companies are posting mediocre returns.

Whether a market index is up or down at the end of the trading day may be all you want to know. But if you’re curious about where that closing number comes from, you’ll need to understand how changes in an index are calculated. Index values are calculated on an ongoing basis throughout every trading day. An index’s methodology specifies the calculation formula, which varies from index to index, though market- capitalization equity indexes generally require similar data: Prices of the stocks in the index at a series of particular moments—for example, the S&P 500 is updated every 15 seconds during the trading day. The number of outstanding shares for each company has in the index. Weighting factor, which is used to find number of floating shares and a divisor, or scale factor.

The total return of a stock index like the S&P 500, which is widely quoted as a benchmark for stock performance, is a calculation that depends on the change in the index, either positive or negative, plus reinvested dividends. Since an index is not an investment, but a statistical computation, however, the reinvestment occurs only on paper—or more precisely, in a software program. Rather than reinvesting dividends in the stocks that pay them, the index provider reinvests all dividends in the index as a whole. Total return on an index is calculated daily, though the results are more typically provided as monthly, annual, or annualized figures, expressed as a percentage.

Contributions from the book Index Investing in this press release are used with permission from Light Bulb Press.