The Dow Jones Industrial Average. The Standard and Poor’s (S &P) 500. The NASDAQ Composite. The FTSE 100. The NIKKEI. The Hang Seng. The Russell 2000. These are all names of stock market indexes in the United States and around the world.
Although you may have heard of these few before, there are well over 3 million stock market indexes. There are indexes in the United States, Canada and Mexico. Stock indexes are common in the United Kingdom, France and Germany. There are stock indexes in China, Japan, South Korea, Israel, Chile, Sri Lanka and even Botswana and Ghana.
Definition of an index
So what is a stock market index?
An index is a measure of a portion of a stock market. An index helps investors determine their investment return in a specific market. An index measures the change in a financial market as stocks are bought and sold.
For example, the S&P 500 measures about 500 of the largest capitalized stocks in the United States. The FTSE 100 measures 100 stocks on the London Stock Exchange with the greatest capitalization. (The acronym “FTSE” is pronounced “footsie.” FTSE stands for the “Financial Times Stock Exchange.”)
The words “capitalize” or “capitalized” or “capitalization” are often used in discussing stock market indexes. These words simply refer to the monetary value of all the outstanding shares of a company that are publicly traded. The S&P 500 is considered by many the premier index to track stock markets in the United States. Although it represents the stocks of 500 corporations, not all the stocks carry the same weight, or, we could say, represent the same percentage in the index. The stocks with a greater market capitalization represent a greater percentage in the index. On the other hand, stocks with a lesser market capitalization represent a lesser percentage in the index. The S&P 500 is a capitalization weighted index. For example, in the S&P 500, Microsoft (MSFT) represents a greater percentage of the index than a company like Hormel Foods (HRL).
Stock indexes can measure markets globally, regionally or nationally. Stock indexes can also measure the movement of stocks in different industries. Here are just a few, some we have already mentioned:
- Russell 2000
- S & P 500
- Dow Jones Industrial Average
- FTSE 100
- Hang Seng
- Shanghai Stock Exchange (SSE) Index
- NASDAQ 100 Technology Sector Index
- Euro Stoxx 50
3 ways to invest in an index
Since indexes represent markets and market sectors, an investor may want to own all the stocks in an index. But to purchase positions in 2,000 different stocks or 500 or even 100 could be very impractical, if not prohibitively expensive. So the industry has developed three ways an everyday individual investor can purchase stocks that are represented in various stock indexes. You can own a slice of all the stocks in an index by purchasing shares of an investment company or an exchange-traded fund (ETF).
Investment companies pool together funds from individual investors and invest that money into stocks, bonds and other financial instruments. The hope is that an investment company will manage money better than an individual investor is able to do. Investment companies sell their shares to the public.
Open-end mutual funds
There are two different types of investment companies that we’d like to focus on. The first is an “open- end” management company, which most people know as a mutual fund. An open-end investment company—a mutual fund—continuously sells its own shares. A mutual fund can raise an unlimited amount of money. A mutual fund can buy stocks, bonds and other financial instruments. When it comes to stock open-end mutual funds, each share an investor purchases represents a slice of the stocks that the fund owns. Each share gives the investor the right to the capital gains as well as the income the stocks produce in the fund. A stock index mutual fund invests in all the stocks represented in the index. So an S & P 500 stock index mutual fund invests in all the stocks of the S & P 500. If an investor owns just $50 worth of this stock index mutual fund, that $50 has a right to a proportional slice of the income and capital gains of all the stocks in the S & P 500.
One example of a stock index mutual fund (open-end investment companies) is the Vanguard 500 Index Fund Admiral Shares (VFIAX).
Closed-end mutual funds
The second kind of investment company is a “closed-end” mutual fund. A closed-end fund conducts an initial public offering (IPO) to raise money. It sells a fixed number of shares. Once those shares have been sold in the IPO, the fund is closed to new investors. The shares then trade on a stock exchange like the shares of a regular stock. A commission is paid to buy or sell the shares.
Closed-end mutual funds are not as popular as they once were. Here’s an example of a stock index closed-end mutual fund Nuveen NASDAQ 100 Dynamic Overwrite Fund (QQQX)
Exchange traded funds (ETFs)
Most popular today are exchange traded funds, or ETFs. ETFs are open-ended investment companies. They issue shares in large blocks called “creation units.” Creation units are then split up by large investors and institutions. These individual shares are then sold to individual investors who purchase them like stocks on stock exchanges. Commissions are paid for both buying and selling ETFs.
Unlike regular open-ended mutual funds, ETFs can be purchased on margin and even sold short. We’ll talk about margin accounts and selling stocks short in future posts. For now let’s just say that buying stock on margin is the same as buying stock on credit — an investor buys a portion of their shares with money borrowed from their broker-dealer. Selling short means that you sell your shares at a high price and then you buy them back at a low price. Selling short is simply buying low and selling high in reverse. ETFs usually have lower management expenses than regular mutual funds. Also, unlike regular open ended mutual funds, ETFs usually have no tax consequences until they are sold. Regular mutual funds distribute capital gains and income annually.
ETFs have become very popular in recent years. An example is the SPDR Dow Jones Industrial Average ETF (DIA).
Are index funds for you?
Some investors have said that an index fund can be just as effective and as profitable as an expensive money manager. If that’s your opinion then purchasing shares in an index fund may be for you. There are open-end index mutual funds, index closed-end funds and index ETFs. There’s something for everyone that will serve your investing needs.
Andrew Sorlie has been an investor for 40 years. He has worked for two major brokerage firms.