While there are many securities and commodities markets, there are even more market indexes, including for art markets, these days.  Market indexes are meant to represent some sort of all-in-one measure of market prices for a particular market.  There are composite indexes of the various exchanges, like the NYSE composite index.  Often, indexes are weighted averages of the individual stocks (or other assets) that they include, with the weighting depending on the relative market capitalizations or on the relative prices of the components.  Other indexes include stocks from various exchanges, not just one.  The Dow Jones 30 Industrial Averages, the DJIA, includes 30 so-called blue chip stocks, the icons of industry, from both the NYSE and the NASDAQ.  There are also the Dow Transports and the Dow Utilities indices composed of stocks of companies in the transportation and the utility industries, respectively.  There is a basic difference in computations of indexes, like the NYSE and the DJIA.  The former is an example of a capitalization weighted index, while the latter is a price weighted index.

The index business, itself, has become big business, and index compositions have become more effective.  Simple price weighting, as that used in the Dow Jones 30 stocks, might not be appropriate when considering a large set of diverse stocks of divergent total market capitalizations.  Other adjustments have also become part of the index constructions mainstream, as we shall discuss, subsequently.  Indeed, even the NYSE Index has recently redefined itself; in the figure, we show the differences in its old and new definitions.

To summarize the differences in the old and the new NYSE index, exchange-traded funds and derivative instruments have been eliminated in the new construction.  In that regard, index funds and other exchange traded funds, which are, themselves, portfolios of stocks, not pure stocks, have been taken out of the index, as have other derivatives products, which also are not true stocks.  The change to a float-adjusted market capitalization basis means that the market floats of all of the component companies are adjusted to reflect the true amount of shares that are available for public trading, eliminating certain shares that are effectively out of the public domain.  That can make a large difference, especially in many of the newer foreign markets.  For example, when the Russian Trading System (RTS) changed reporting of its market capitalization to a float-adjusted basis in 2004, the capitalization decreased by about two-thirds.

Also new was the creation of a total return index, in order to account for dividend returns, which is useful for making comparisons of real stock and portfolio returns to the index.  In total return indexes, such as those that have been created recently for the NYSE and the NASDAQ, the index is calculated in a manner that assumes that all dividends are reinvested as they are received.  In that regard, whereas traditional price indexes can provide a measure of capital gains on stocks, in the aggregate, the total return index gives a broad measure of return, including dividends and capital gains.  It is especially difficult for an investor to get a handle on total return, on her own.  On the one hand, the dividend yield for all stocks on the NYSE is around 1.5 percent per year, but it is quite useful to have the higher precision of a company-calculated total return index.  Again, such an index will have different meanings and significances to, for example, a tax-free institutional investor and a tax paying individual.  We shall discover other types of weightings and adjustments when we discuss international stock market indexes and investing.

It will be instructive to take some time to look at example computations of the two more common types of indexes.  In computing a price weighted index, the prices are all added together, and the result is divided by the number of stocks, like in the case of the DJIA, 30.  In that regard, a percentage change in the average summed index is equal to the sum of the percentage changes of each member of the average. 

For a capitalization based index, percentage changes in the larger capitalized component will have a greater affect on the index.  For example a 10% change in the smaller component of the AB index would correspond to a 3.3% change in the index, while a 10% change in the larger component results in a 6.6% change for the index.  Therefore, understanding the construction of an index is necessary for understanding the information that it conveys.

There are other well-known capitalization weighted indexes for the U.S. stock markets.  One is the Standard and Poor’s (S&P) indices: including the S&P 500, the top 500 stocks as rated by S&P, the S&P 100, and even composites of certain sub-class stocks.  Other indices, like the Wilshire 5000, include over 6000 stocks from the NYSE, the AMEX, and the NASDAQ.  Some of the Russel indexes include securities on an international scale.  Morgan Stanley Capital International (MSCI) maintains and publishes index for a large number of international investment portfolios.  Therefore, care must be taken in garnering information from such indexes.  The DJIA tells us only what is happening with prices of 30 better stocks, which information might not apply to all stocks.  The S&P index gives a better view of stocks, but the more general course of stock prices, like in the NYSE or the Wilshire 5000, may be different from even the broader S&P 500 view.  There are also bond, commodity, investment fund, and art market indexes.

Moreover, you will find that all stock markets around the world have several indexes associated with them.  For example, there are the Nikkei 225 and the TOPIX indexes for the Tokyo Stock Exchange, the FTSE All Share and the FTSE 100 for the London Stock Exchange, the WIG and the WIG 50 for the Warsaw Poland Stock Exchange, the TASI in Saudi Arabia, the CASE 30 on the Cairo and Alexandria Exchange, the LuSE index for Lusaka, Zambia, and the TEPIX in Tehran.  Often, there are indexes for a particular exchange created by the exchange, itself, and by outside companies, like FTSE, S&P, MSCI, and Dow Jones.  To be sure, a great demand for indexes has come from institutional investors and investment fund managers who will use indexes as benchmarks for portfolio construction and performance evaluation.

We point out that the specific stocks that are included in these indexes can change over the years.  For market composite indexes, like the NYSE Composite index or the NASDAQ Composite, the indexes naturally change as new stocks get listed and old stocks get delisted.  Even, indexes that maintain a set number of stocks change their composition, periodically.  For example, before the 1929 stock market crash, the DJIA included such names as International Nickel and Victor Talking Machines, which you would not even recognize, today.  Indeed, at this point in time, knowledge of stocks that will be removed from or added to an index has risen to the level of inside information.

In order to get information from market indexes, you have to understand how the index is composed and what information it gives you.  When we recently asked Artron, an art market information service, in China, how their various Chinese art market indexes were constructed, no one could actually tell us, and they said that we were the first to ever ask.  Investment advisors even play games with indexes.  For example, fund of fund managers and brokers have indexes of their funds, but as old ones leave the index and new ones are added, there is a natural bias to the upside, as losers are eliminated and winners are put in.

© Craig L. Mattoli 2004-2010 All rights reserved.  No part of this monograph may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without prior express written permission from Craig L. Mattoli, RedHill Capital Corp., Delaware, U.S.A.: clm@clmattioli.com.