What is an Index?
Everyone has probably heard of an index on the stock exchange, usually known as a stock index. This is because the performance of the most important national index is often mentioned in the news on TV. However, in addition to the well-known stock indices, there are many others. In this article, we explain the function of such an index and how it works, focusing on the stock indices.
The Composition of an Index
In an index, a certain group of assets, the so-called basket, and their performance are shown in an overall picture. As the name suggests, this is a group of specific stocks in a stock indices. These must fulfill certain conditions in order to be included in the respective index. Depending on the weighting of the individual components in the index, these conditions can influence the respective price of the index.
Weighting of the Index Components
The influence of the individual components on the price of an index depends on the way in which the components are weighted. This can be done in different ways, as shown below.
The components in an equally weighted index all have the same weighting. This means that criteria such as the stock price of individual components have no direct influence on the performance of the index. However, as the prices of the index components are constantly moving, sometimes in opposite directions, the weighting of individual components must be adjusted relatively frequently.
The performance of a price-weighted index is determined by the prices of the individual components in the index. In such an index, all components are represented in equal numbers. Accordingly, the stock prices in a price-weighted stock indices have a major influence on the weighting of the respective stock in the index. Price-weighted indices are, for example, the US Dow Jones Industrial Average or the Japanese Nikkei 225.
Index weighted by Market Capitalization
When weighting by market capitalization, the number of shares issued is multiplied by the current stock price. The result of this is then divided by the sum of the market capitalization of all stocks represented in the index, which gives the weighting of the individual stock.
Index weighted by Free Float Market Capitalization
This weighting is basically the same as the weighting by market capitalization described above. However, the market capitalization is adjusted for stocks that are not publicly traded. These can be stocks that are held by the founder of the company, for example. This means that only those stocks that are traded in the open market are included in the calculation of market capitalization. Indices that are weighted using this method include the US S&P 500 and the German benchmark index DAX.
Investing in an Index
It is not possible to invest directly in an index such as the Dow Jones or the DAX. If you want to invest in an index, you have to use financial products that track the index in question. The best-known example of this is exchange-traded index funds, better known as ETFs. These track the index on a one-to-one basis and give investors the opportunity to benefit from the positive performance of an index. Another option is to trade in derivatives on indices. These are usually leveraged financial products that allow traders and investors to speculate on the performance of an index. However, due to the costs associated with them, they are generally more suitable for the short-term investment horizon. Furthermore, leveraged derivatives are complex instruments and, due to the leverage involved, carry a high risk of losing money quickly, making them not suitable for all investors.