July 14, 2020
Many investors may wonder how indices and benchmarks relate within the world of finance. The terms are often related, as we’ll soon see. An index is simply a basket of securities that can be used to measure the performance of the particular market. There are indices for stocks, bonds, commodities, currencies, and even attributes of markets such as volatility.
For equities, perhaps the most famous index is the Dow Jones Industrial Average, which presently measures the stock price performance of 30 industrial companies that represent a broad range of industries. The Dow Jones is a price weighted index, which simply means that the index represents the average price of each of the components. When it was first constituted in 1896, the Dow Jones was the average price of 12 stocks, most of which would not be familiar names today, with the exception of General Electric (GE), which was finally dropped from the Dow in 2018. As a price weighted index, the Dow Jones Industrial Average is calculated based on the sum of the prices of each component stock, divided by the Dow Divisor. In 1896, the divisor was simply the number of stocks in the index, but that divisor has been significantly adjusted over time to reflect changes in the index, including stock splits and dividends, additions or deletions of companies to the index. As of late 2019, the Dow Divisor stood at approximately 0.1458, which means that the value of the index is approximately 6.86 times the value of the sum of the prices of the 30 components (since this is dividing by a number smaller than 1). This means that for any stock in the index, a $1.00 move in any stock price will result in a 6.86 point move in the index.
The other main market index that is often quoted is the Standard & Poor’s 500 (S&P 500) index. The S&P 500 is a market weighted index rather than a price weighted index like the Dow Jones. Put more simply, this means that of the stocks in the index (currently, there are 505, due to multiple share classes), those with higher market capitalization will have a greater weight in the index than smaller market capitalization companies. Here, market capitalization is defined as the stock price multiplied by the number of shares in the free float. As a result of this market weighting, the S&P 500 is one of the broadest indices, covering approximately 80% of the available market capitalization in the total market. On the downside, market weighted indices like the S&P 500 can be more heavily influenced by larger components, which may result in misleading signals relative to the broader market, such as recent periods when Apple, Google and Amazon have performed strongly, and ultimately lifted the index, even as many smaller companies underperformed.
Benchmarks are a subset of overall indices, as most commonly used benchmarks are one or more relevant performance index. Think of it as portfolio managers being graded on a curve. Suppose, for example, I told you that the fund I manage has returned 6% over the past five years. If my management of that fund good or bad? That depends on what I am comparing it to, or the relevant benchmark. If I am managing a fund that invests in mining stocks, and the Philadelphia Gold and Silver Index (XAU) was up just 4.5% during the same period, then my performance was good. However, if I was managing a technology fund and the Nasdaq Composite Index was up 12.5% during the same period, I would be in trouble. So, most fund managers will work to establish the most relevant benchmark based on the investment objectives of the fund, thus providing a more realistic “curve” on which to be graded. These benchmarks are disclosed in fund prospectuses to help guide and asses performance metrics for mutual fund you may invest in, providing insight into the overall performance objectives of the fund.
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