This is part 1 of a 2 part series.

Whether you are using market indexes as benchmarks to track the potential performance and risk of a given investment or you are engaged in index investing, indexes have something to offer every investor. 

Thoughtful investors can gain significant insight on the market’s behavior by studying index values and understanding what the numerical changes in indexes might represent. To help give you the context for judging index performance, it helps to first know what goes into the numbers reported by common market indicators.

What Is an Index, Really?

An index is a select group of investments whose collective performance can be taken to represent a market as a whole, or at least a clearly defined subset of that market. While some indexes may be recalculated once a day or less, indexes representing large, liquid and active markets (such as the US stock market) are typically recalculated continuously during trading periods to reflect up-to-the-moment pricing data and to indicate the direction and magnitude of the market’s price sentiments.

Of course, major US equity indexes are not simply the sums of the individual prices for the investments they represent. Rather, indexes such as the S&P 500 and Dow Jones Industrial Average are statistical models of the universes they were created to mirror. They take the latest prices and adjust them to better reflect long-term changes in financial markets, the constituent companies and the economy. 

The numerical values of common indexes do not directly convey either the actual daily prices or percentage changes of their constituents, and when viewed as isolated points of data, major indexes typically provide little or no actionable significance. Rather, index values are intended to be viewed in a series so they can provide time lines that can chart relative performance from a consistent foundation. An index value today can be compared with its value days, years or even decades in the past to give a meaningful estimate of how the market might have changed over that time. 

The components for each index are chosen according to the stated rules and policies of that index. Moreover, each index’s value is calculated using its own proprietary formula. As a result, even though two or more indexes may include the same company in their statistics, any particular market price change for that company is likely to have different effects on each index.

Distinguishing Among Different Indexes

The most commonly cited stock indexes in the United States—benchmarks such as the S&P 500, the Dow, the Morgan Stanley Capital International’s EAFE and Russell Investment’s Russell 2000—are actually parts of large index families. Some indexes in those families focus on specific areas of the market, such as large, midsized or small companies. Others specialize in sectors or investing styles such as growth and value. Each index has its own unique philosophy and methodology you should consider. Here are overviews of some of the key factors you can use to compare them:

• Coverage Criteria Some indexesuse rigid statistical rules to select their constituents. For example, Russell Investment Group ranks substantially all publically traded stocks by their total market value, and then assigns each company on that list to an index based solely on its position on that list. Others use more fluid processes. For example, Standard & Poor’s analyzes and weights the relative importance of each business sector in the economy. It then selects cross-sections of companies from each sector to create stratified samples that mirror the market.
• Diversified or Focused? Among the most commonly quoted market benchmarks, the S&P 500 and Russell 1000 can be considered diversified, while the Dow Jones Industrial Average is not. Rather, it is composed of 30 of the largest and most venerable companies in the US economy. What the Dow might lack in market breadth, it could make up in depth—it has been calculated continuously since 1896, allowing direct performance benchmarking that stretches for more than a century.
• Sector Segmentation Many providers of diversified indexes segment their primary indexes into sector subsets. However, the definitions of sector vary, with different classification schemes in use. The Global Industry Classification Standard (GICS) was developed jointly by Morgan Stanley Capital International and Standard & Poor’s and forms the basis for each of these firms’ index sector distinctions. GICS is composed of 10 sectors, each of which includes one or more industry groups drawn from the GICS list of 24 such groups. The North American Industrial Classification System (NAICS) and its ancestors such as the Standard Industrial Classification (SIC) system are widely used by economists, the Securities and Exchange Commission and some other index providers. This system defines more than 400 individual industries in the economy, each of which can be grouped into one of 24 different sectors. An investor looking to use indexes for a sector rotation strategy should consider the classification systems used by the indexes.
• Market Capitalization and Float In the context of indexes, there are no universally applicable definitions for large-cap, midcap or small-cap. A company that is listed as small in one provider’s universe may be considered medium or large in another’s. That’s because some index providers view only market value when making their groupings, while others may adjust their categorizations to reflect variances in company age or maturity, business factors and growth rates. Float is another factor that leads to variation. Some index providers consider all shares equally when assessing the size of a company. Others consider only the value of shares that can be publically traded, a statistic known as the free float. For example, a company with a large number of shares held by insiders who are bound by trading restrictions will have a much smaller free float than a similar-sized company with no stock subject to trading restrictions.
• Weighting is the practice of adjusting each constituent’s contribution to the index to reflect its relative size in the index. Weighting is most typically based on price per share or total company size. In price weighting, a stock whose share price is $20 will have twice the influence on the index as a stock whose share price is $10. In capitalization weighting, a constituent whose total market value is twice as great as another’s would have twice the influence on the index. The DJIA, for example, uses price-weighting factors in its calculations, while the S&P 500 uses capitalization-weighting factors. 
• Company Domicile Major stock indexes in the United States all reflect pricing action on US stock exchanges. But some indexes (such as the S&P 500) include companies based outside the United States who list their shares here, while others (such as the Dow and Russell) limit their constituent universes to US-domiciled firms.
• Index Turnover Some firms follow fixed schedules for reevaluating their constituent lists and making changes to those lists. Russell, for example, undertakes this kind of index revision once each year, at the end of June. Others respond more fluidly. Standard & Poor’s analysts continually monitor their index constituents and make changes to their indexes as conditions warrant, sometimes as often as daily or weekly.
• Investability and Tracking Error While it may be impossible to invest directly in any index, asset managers can create portfolios that are intended to replicate index performance. Along the same lines, index architects can design benchmarks that simplify the process of replication for portfolio managers. One important tool for measuring how well a portfolio tracks an index is tracking error. In its simplest statistical form, tracking error is the arithmetic difference between portfolio returns and benchmark returns; the smaller the difference, the closer the manager is to the benchmark.

Investment indexes are complex devices that can be invaluable tools when used properly, or hazardous when used inappropriately. And while you cannot invest directly in any index, you can find investments that mirror the performance of a specified index. Many investors find these investments ideal for certain purposes. I can help you get a better understanding of indexes and also find suitable index-based investments as appropriate to your particular needs. Please feel free to contact me with any questions.

Michael Caplan is a Financial Advisor and Associate Vice President with the Global Wealth Management Division of Morgan Stanley in Denver.  He can be reached at Michael.Caplan@morganstanley.comor (303) 595-2094.

The information contained in this article is not a solicitation to purchase or sell investments. Any information presented is general in nature and not intended to provide individually tailored investment advice. The strategies and/or investments referenced may not be suitable for all investors as the appropriateness of a particular investment or strategy will depend on an investor's individual circumstances and objectives.  Investing involves risks and there is always the potential of losing money when you invest. The views expressed herein are those of the author and may not necessarily reflect the views of Morgan Stanley Wealth Management, Member SIPC, or its affiliates. Morgan Stanley Wealth Management LLC. Member SIPC.