Home Beginner Market Structure Stock Indices and Index Exchange-Traded Funds

Stock Indices and Index Exchange-Traded Funds

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Stock Indices

The health of the stock market has always been thought to be a leading indicator of the economic cycle, the consensus saying that market prices tend to move higher or lower about six months before the economy confirms these movements with improved (or weaker) economic figures. True or not, the fact is that institutional and retail investors alike, by every means available, are continually trying to spot turning points on the economic cycles and the stock market activity that could provide advance evidence of the health of the overall economy as well as of its industrial sectors. The goal of the stock indices is to measure it.

The first index ever devised was created by Charles Dow as a way to measure the health of the overall US economy.  He thought that measuring the strength of the critical Transportation Sector it would give a leading indication where the overall economy was heading to. It called it “Dow Jones Transportation Average”.

One of the most important stock index in terms of market sentiment is the Dow Jones. It was created by the Wall Street Journal editor Charles Dow, co-founder of the Dow Jones & Company to gauge the health of the  US industry. The first Dow calculation was on May 26, 1896, and included just 12 companies. Mr Dow included in the initial index only industrial companies, and he named it “Dow Jones Industrial Average”. The first components were leading companies from the railroad, cotton, tobacco, gas, sugar, electric appliances, and oil sectors.


Chart 1- The Dow Index, Weekly Charts

None of its original companies has survived in the index. General Electric (GE) was the last original Dow company surviving in the average for more than a century, but it was dropped out of the index in June 2018, and surprisingly substituted by Walgreens Boots Alliance (WBA), a leading operator in the retail drugstore sector.

The other index with a “global” status is the S&P 500, which tracks the 500 biggest US companies, and has been published and maintained by the S&P Dow Jones Indices. The S&P 500 is the underlying base for the most liquid Index Futures around the globe: The S&P 500 Futures, with ticker SP,  introduced by the Chicago Mercantile Exchange in 1982.


Widely-known indices are also The FTSE 100, DAX 30, CAC 40 and EURO STOXX 50 in Europe, the Nikkei 225 (Japan), S&P ASX 200 (Australia) and the SZSE Composite ( China).

Currently, there are hundreds, if not thousands of indices tracking every sector of the economy in almost every country on Earth.


How are indices calculated?

Price-Weighted Average

The simplest way and the one Charles Dow had used to compute the Dow: A simple average of the stock price divided by the number of stocks in the index. Over time, the index suffered additions, mergers, stock splits and substitutions. Hence, they created a Dow divisor to avoid not-market-related index point jumps.

DJIA = SUM[Component market price]/Dow divisor.

On this type of average, the price of all companies has equal weight on the resulting value. So it doesn’t work if there is a too wide difference in the size of their components. This type of average is biased toward high-priced stocks.

Free-Float Capitalisation-weighted Average

Not every component holds the same weight in the market. Some components are heavily traded, involving a high per cent of the market’s volume while other’s play a more modest role. To account for this, some indices, such as the S&P 500, Nasdaq 100 and Russell 2000, weigh all components by its available capitalisation (the capitalisation not retained outside the stock market by company insiders) as a previous step before doing the calculation of the average.

Index = SUM[Component_price *ai*Capitalisation]/Divisor

ai = Free float shares

The divisor is a value custom value that changes to account for stock splits, spinoffs substitutions and other circumstances that can modify the index value unrelated to market forces.

This type of average is biased toward large market capitalisation companies.

Equally Weighted Average

An equally-weighted average is computed using the cumulative sum of the per cent returns of its component.

EW Index = SUM[%return_i]

Its growth is similar to investing the same amount in every component of the index. That means, it is biased toward the smaller companies of the index, which are more numerous.  The S&P 500 has an equally-weighted version.  The Value Line Geometric Composite Index is another equally-weighted index.



Index Exchange Traded Funds (Index ETF)

Exchange Traded Funds (ETF)

An ETF is a fund that is traded in Exchanges as if it were a company.  ETF’s was the most significant innovation of the 90ies. This development coincided with the other financial revolution in the markets: the day-trader.

On the one hand, the ETFs were cheaper instruments to trade because the percentage of spread was lower than over $100 share prices. On the other hand, it captured the imagination of the investor who saw the opportunity to invest in low-commission and tax-efficient instruments compared to the conventional closed funds.

This type of product allows investors to access investing products beyond the frontiers of his country. Using Index ETFs from indices tracking the major companies of a country, a British investor can invest in the economic health of India, China, Brazil, Australia, the USA and the rest of the world. He is capable of moving part of his portfolio from a decaying economy to a promising one in seconds.

Today there are ETFs of all kinds and colours: stocks, Bonds, Commodities and currencies have their ETFs listed in the exchanges.

The majority of the ETFs have been Index-tracking products, but since 2008, actively managed ETFs. The first of its class being Bear Stearns Current Yield ETF (YYY).  Managed ETFs are fully transparent, its current list of securities daily listed on its website.

Sector Index ETFs

As we have stated, ETFs are not limited to broad market averages. There are sector ETFs, allowing investing in specific sectors such as Industrial, Healthcare, Technology, Communications, Financial, Oil or metals. Even bonds and volatility have their own ETFs, allowing investors and traders what is called “thematic investing”.

Since ETFs are treated like stocks, they are unleveraged securities. Although this is true, some of them are 2X and 2X leveraged versions of stock indices. Also, some of them are related to 1X, 2X and 3X inverse indices, allowing investors on non-margin accounts to profit from market downturns.

The following table lists the top 15 ETF’s by dollar volume.

Table 1- top 15 ETF’s by dollar volume- Table created with data from etf.com

 

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