3/9/17

A breakdown of how index funds are formed

As we learned in our introductory “Indexes and Your Investments” blog post, index funds are groups of stocks, similar to mutual funds, containing stocks with similar characteristics, such as size, geographic location or profit value. Indexes were originally designed to track particular market segments, and they continue to serve as useful benchmarks for how a particular market segment is faring. For the practical, long-term investor, investing in index funds is also a steady, low-cost investment strategy that earns market returns over time. In this blog post, we break down the inner working of index funds, from how they are structured to how indexes compare to one another.

What makes one index more popular than another?

There are hundreds, if not thousands, of stock market indexes that benchmark everything from individual countries and regions to industry sectors and companies of a specific size. Certain indexes are widely popular, while others are lesser known. So, what makes one index more prominent than another?

The popularity of certain indexes over others is primarily driven by popular appeal. Just like competitive market forces, indexes too are subject to the natural order of things. Sometimes, the “best index wins”, while other times it may not.  In short, what makes one index more widely accepted as a benchmark than another is partially arbitrary.

How are indexes structured?

Two of the most prominent U.S. indexes, the Dow Jones Industrial Average and S&P 500, track the same market segment, the U.S. stock market, but the calculations each index uses differ. The Dow uses a price-weighted average of the 30 leading U.S. companies across various industries, while the S&P 500 takes the market value-weighted average of 500 large, reputable U.S. companies.

How the top companies within each index are chosen also differs. S&P 500 companies are selected by a board that uses a fixed set of criteria including companies with:

  • Market cap of more than $5.3 billion

  • Four consecutive quarters of positive earnings

  • Adequate liquidity

  • Public float (total number of shares available for trading) of at least 50%

The Dow’s Average Committee also has its own proprietary set of criteria it uses to select the top 30 companies; however, rules for the stocks’ inclusion in the Dow are a bit broader and the composition of the Dow’s top 30 companies rarely changes.

Indexes may be approximate and arbitrary, but useful nonetheless

Because of the differences in how indexes are calculated, indexes are not hard and fast barometers of how markets are faring. Instead, they are approximations of actual market performance. Despite the fact that indexes can contain flaws, they serve as simple, convenient financial models to measure slices of capital markets.

According to Nobel Laureate Eugene Fama, “No model is ever strictly true. The real criterion should be: Do I know more about markets when I’m finished than I did when I started?”.  

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