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The Dow Jones Industrial Average, S&P 500 and the S&P/TSX Composite Index are familiar names to even the most casual readers of the business pages, but it can be difficult to understand how these indexes work and what’s behind their spikes and drops. Here’s what you need to know.

What is a market index and what do they do?

A market index is a collection of stocks, bonds or other investments that helps investors understand the health and performance of the broader market, or a specific subset of it. Indexes can comprise hundreds or even thousands of securities, or even just a handful: while the Dow follows 30 companies, for example, the Centre for Research in Security Prices’ CRSP U.S. Total Market Index follows almost 4,000. The goal of each index to be representative of the market it is tracking.

Indexes also function as benchmarks for the creators of index funds or index exchange-traded funds.

Indexes are measured in points, which are calculated in a variety of ways, depending on the index’s weighting system. Their value will change throughout the day as the prices of their underlying securities move up and down as they’re traded.

Where did market indexes come from?

The Dow Jones Transportation Average is the oldest U.S. stock index. It was created in 1884 by American journalist Charles Dow, who, with Edward Jones, co-founded Dow Jones & Co., publisher of The Wall Street Journal. The index initially comprised 11 companies – nine railways and two nonrail – and is today made up of 20 companies.

Mr. Dow soon felt that transportation companies gave investors only a partial understanding of the economy and that industrial companies, while considered “highly speculative” at the time, were a key component of the United States’ economic growth. That prompted him to launch the much better-known Dow Jones Industrial Average in May, 1896. The intent of the DJIA was to represent the broader United States economy – though, of course, that looked a lot different than it does today. The initial version was made up of just 12 stocks, including a leather-maker, a sugar producer and a steel company. Today the Dow is made up of 30 blue-chip stocks, including Apple Inc., Goldman Sachs Group Inc., Coca-Cola Co. and Microsoft Corp. The index is calculated by adding up the prices of all the constituent stocks and dividing the sum by a divisor.

What is the stock market and how does it work?

As of 2019 there were a whopping 2.96 million indexes globally, according to the Index Industry Association (IIA) – a combination of global and national equity and fixed income indexes, and more specialized indexes tracking various industries or sectors.

In the past decade, indexes focused on technology companies and on firms seen as sustainable have become particularly popular, reflecting the interests of millennial and Gen Z investors, says Aye Soe, managing director and global head of the product management group at S&P Dow Jones Indices, which owns the Dow Jones indexes as well as the S&P 500, S&P/TSX Composite and others. Environmental, social and governance-focused indexes increased 43 per cent from 2020 to 2021, and 40 per cent from 2019 to 2020, the IIA found in its annual global benchmark survey.

How are indexes constructed?

Each index has its own approach to determining which companies should be included or removed, depending on its mandate. Requirements to be included could be based on company size, market capitalization or stock price; a company’s free float, or the amount of its stock that can be publicly traded; minimum years as a public company; and other criteria.

For example, the S&P 500, an index of the 500 largest U.S. public companies that aims to represent the broader U.S. economy, requires companies to have a minimum market cap of US$14.6-billion, to trade on the stock market for at least a year and be listed on a select group of exchanges. The S&P/TSX Composite, its Canadian counterpart, requires possible entrants to be headquartered in Canada and meet certain liquidity and market cap thresholds. (And, of course, to be traded on the TSX.) The S&P/TSX 60, an index of large-cap Canadian companies, has certain rules about share turnover, or how often the stock is traded, and has a goal to maintain sector balance in the index.

Other well known indexes, such as the NYSE Composite and the Nasdaq 100, only follow companies listed on those specific stock markets.

The DJIA is a rare exception to many common index construction rules, with a less quantitative methodology. To be added, companies must be in nontransportation and nonutility sectors (there are separate Dow Jones indexes for those industries) and be listed in the S&P 500. The index requires companies have an “excellent reputation,” prove sustained growth and be popular with investors. “It’s quirky, in a sense, because of this century-old tradition,” and narrower even though these days there are more than just 30 large-cap companies, Ms. Soe says.

Why should I pay attention to indexes?

Indexes are useful for understanding how the economy and specific sectors are faring. Looking at historical index data can also tell you how markets have responded to similar situations in the past, such as periods of rising inflation, rising or falling interest rates and more.

They’re also meant to act as a benchmark that investors can use to compare their own holdings to, whether a mutual fund or an individual stock, to determine whether they’re over- or underperforming against the market, Ms. Soe says.

It’s important to understand the characteristics of the index you’re following. While you might assume the S&P/TSX Composite would be similar to the S&P 500, they have notable differences because the composition of the two countries’ economies is different, with the U.S. more tech heavy, and Canada’s historically dominated by financial, natural resources and materials companies. (However, as Rob Carrick, The Globe and Mail’s personal finance columnist, noted in December 2021, the S&P/TSX has become much more sector-diverse over the past few years.) This means that indexes in different countries may respond slightly differently to positive, or challenging, market conditions.

How are companies added to or removed from an index?

Stocks or other securities are added to an index once they hit the technical thresholds the index provider has laid out. This is usually after an increase in their market capitalization or stock price or a sustained earnings increase, among other factors. Companies can be dumped if they experience challenges on these metrics. In some cases where the index has a fixed number of companies, a company can be dropped to make room for a new entrant, even if it was still performing well.

This can happen in a variety of ways: some indexes have a committee to evaluate new entrants, while others – such as the Russell 1000, 2000 and 3000 indexes – add and delete companies once a year.

Ernest Biktimirov, a professor of finance at Brock University’s Goodman School of Business who has published studies on indexes, notes that being added to or removed from an index can have a significant impact on a company. Once added to an index, a company’s stock will see major buying pressure, driving prices higher, as index-based mutual fund and ETF managers scoop up its stock to keep up to date with the index. Similarly, being booted from an index can lead to a sell-off, causing the stock price to drop. Investors often try to anticipate these market moves, he says.

What is index weighting?

Once index managers have picked the companies or investments that will be included in the index, they decide on how to weight them. The three most common index weighting approaches are market capitalization-weighted, equal-weighted and price-weighted.

Market capitalization weighted means simply that the largest companies in the index have the largest weight on the index and smaller companies make less of a dent when their price moves.

Some index providers will offer different weighting options for the same index, Ms. Soe says. Equal weighting, where each company has an equal influence on the index’s performance, is a particularly popular approach, she said. “When you equal weight them it gives the index more of a smaller-cap tilt because you’re assigning equal weight to everyone,” she says.

Price weighting is much less common these days, Mr. Biktimirov says. In this construction, companies with higher stock prices have an outsized influence on the performance of the index. “There’s not any economic justification or rationale that high-priced stock should have a higher weight,” he says.

Can I invest in an index?

Indexes themselves are not investable products. However, you can invest in an index mutual fund or exchange-traded fund that tracks the performance of a given index.

Mr. Biktimirov recommends investors, particularly those who are newer to investing, put some money in an index fund. These funds instantly provide a diversification benefit by splitting your funds between all the index’s constituent companies across many sectors, and they grant exposure to companies with stock that it may be too expensive to purchase on your own, such as some U.S. tech stocks.

He noted, however, that some indexes and their corresponding index funds are highly specialized on particular segments of the economy, such as biotechnology, semiconductors, health care or banking. Investing in these doesn’t offer the same diversification benefits as a broader market index does.

“Now it becomes like a stock-picking game, but not at the level of individual companies – it becomes at the level of individual sectors of the economy,” he said. “If investors buy these particular index funds they’re effectively making a bet it will outperform other sectors of the economy.” Outperforming the stock market is a very difficult thing to do on a consistent basis, he added.

While the rounding out of the S&P/TSX Composite has improved diversification benefits for Canadian index fund investors, Mr. Carrick says it’s still “hugely” beneficial to get exposure to stock markets in the United States and other markets through other index funds. He points out, for example, that “the S&P 500 has a weighting of almost 30 per cent in tech, and 13 per cent in health care. The S&P/TSX weighting in health care is still a puny 0.8 per cent.”

Do index funds differ from the indexes they’re based on?

Jasmit Bhandal, chief operating officer of Horizons ETFs Management (Canada) Inc., an ETF creator, said it’s important for investors to understand that while index funds and ETFs are built to replicate the performance of an index, it will generally “never be perfectly aligned” because of fees such as the management expense ratios that come with mutual funds, or the fee and transaction costs associated with ETFs.

Index fund makers and the index they’re replicating may also diverge slightly for practical reasons, Ms. Bhandal says. She gives the example of broad market fixed income indexes, which include thousands of bonds. “It would be highly expensive and inefficient to buy every single one of those bonds,” she said, noting that this can also happen with equity indexes, mostly with very small or illiquid companies.

In that case, the index fund creator will omit some securities while optimizing the fund to ensure it still matches the major characteristics of the index.

She also noted fund managers can choose to weight an index fund differently than an index creator has in order to achieve risk and return goals for investors.

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