Stock market indices are the backbone of market measurement, but how are they calculated?
Welcome to the world of stock market indices. Whether you’re a seasoned investor or just starting out, understanding how these indices are constructed is crucial for navigating the financial landscape. In this piece, we’ll explore the key components of index construction, including market capitalisation, free float adjustment, and index performance calculation. Additionally, we’ll delve into some well-known international market indices and the index providers behind them.
Market Capitalisation: How big is my company
Market capitalisation is a fundamental concept in constructing stock market indices. It refers to the total value of a company’s outstanding shares: the number of shares multiplied by their current price. In index construction, stocks are typically selected based on their market capitalisation, ensuring that larger companies have a greater impact on the index’s performance. A company with a higher market capitalisation will have a larger weight in the index compared to a smaller company. This methodology is often used in indices like the S&P/ASX 200, which tracks the 200 largest publicly traded companies in Australia. Indices like this are called “capitalisation-weighted indices”. The method is simple: find out how many shares of a company are on issue and multiply them by the current price; this is the company’s market capitalisation. Rank companies by this number and you have a list of the companies on the market by size.
Float Like a Butterfly
To accurately reflect the investable universe and ensure that the index represents shares that can be freely bought and sold, free float adjustment is employed. Free float refers to the portion of a company’s shares available for trading in the market. Some companies’ shares are owned by insiders such as the founders, strategic investors or government entities and can be considered unavailable for sale. By considering only the shares available for public trading, free float adjustment ensures that the index represents the market’s true investability. This adjustment is particularly important in emerging markets where large holdings by insiders or the government are common. Most well-known indices employ a free float adjustment to maintain accuracy.
Quarterly Rebalance
Generally, the index providers will recalibrate their indices every three months. They add in any newly-issued shares for each firm, subtract any shares that were bought back by the company and recalculate and rank the free-float market capitalisation. This becomes the new index. Depending on how share prices have changed during the preceding three months stocks will drop out or be added to the new index.
What’s happening on the market
Once the constituent stocks and their respective weights are determined, calculating the index’s performance becomes crucial. There are different methodologies for performance calculation, but the most common approach is the market capitalisation-weighted method. In this method, the value of the index is calculated each day and the difference from one day to the next is used to figure out the index performance. So when you hear on the nightly news that the market was up 1% today, it’s this change they’re talking about. It gives a good indication of the general trend of the market for the day.
Meet the Index Providers
Several index providers play a vital role in constructing and maintaining stock market indices. Three prominent ones are:
1. S&P Dow Jones Indices: S&P Dow Jones Indices is a leading provider of global indices, including the S&P 500 and the Dow Jones Industrial Average (DJIA). The S&P 500 is widely regarded as a benchmark for the U.S. equity market, while the DJIA represents 30 large and well-established companies. In Australia, it’s S&P’s ASX 200 index that is often used.
2. MSCI Inc.: MSCI Inc. is renowned for its global equity indices, such as the MSCI World Index and the MSCI Emerging Markets Index. The MSCI World Index encompasses developed market stocks from around the globe, while the MSCI Emerging Markets Index focuses on stocks from emerging economies.
3. FTSE Russell: FTSE Russell is another prominent index provider, known for indices like the FTSE 100 and the FTSE All-World Index. The FTSE 100 tracks the 100 largest companies listed on the London Stock Exchange, while the FTSE All-World Index covers both developed and emerging markets.
Performance Benchmark
The movement of the index value over a day, month or year is used by fund managers to gauge their investment performance. Most fund managers benchmark themselves to the performance of an index which closely represents the market in which they’re investing. Passive index managers will aim to exactly match the performance of the benchmark index while active managers will try to do better. By comparing performance to an index a potential investor can reliably understand if the fund manager is doing their job well.
Stock market indices serve as important barometers of market performance and provide investors with a snapshot of the overall market movement. Market capitalisation, free float adjustment, and index performance calculation are key components in constructing these indices. Understanding these factors helps investors gauge the performance and trends of various segments of the market. Furthermore, index providers like S&P Dow Jones Indices, MSCI Inc., and FTSE play a vital role in creating and maintaining these indices. And with popular international market indices like the S&P 500, FTSE 100, and S&P/ASX 200, investors worldwide can gauge the pulse of their respective markets.
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