Index funds have gained in popularity over the years as the preferred method of investing. I often get calls from people who tell me they want to invest in an index fund. There are literally hundreds of thousands of different index funds.
The index fund itself can be made up of bonds or stocks and mimic a financial market index. We know how good the index fund is at doing its job by the tracking error, that is how close are the returns of the fund to the index that it is tracking. But what of the that financial market index they are tracking? How is that made up? I am going to look at three of the most common indexes and we will look at how companies make it into that index.
When you hear Donald Trump boast about how well the American economy is doing, he is basing it on the price of the Dow Jones (he still does not understand the difference between the market and the economy!).
The Dow Jones is made up of the performance of 30 large cap US companies. The value of the index is the sum of the price of one share for each company divided by a Dow Divisor which is currently 0.14748.
When set up originally by Charles Dow in 1896, it was seen as a good indicator of the US economy as a whole. Now, with only listing large cap companies, it is less representative. There aren’t any preset rules on how to be one of the 30 companies in the Dow Jones, it is simply when it seems warranted and when there is a replacement, it doesn’t necessarily be with another company in the same index. Some see the Dow Jones as outdated.
The MSCI World Index is a common benchmark to represent a broad cross section of the global market, investing in 1,600 different companies. MSCI is the name of the company that maintains the index (formerly Morgan Stanley Capital International) It doesn’t actually represent the whole market, just 23 developed world countries (the all country world index includes emerging markets).
The index is reviewed every February, May, August and November and reblanced twice a year using a number of criteria (136 page document). The index invests in small and medium sized companies as well as large cap to give a good representation of the global market. The index is market cap weighted, which means that stocks are weighted according to their market cap, so larger companies have a larger weighting.
The S&P (Standard and Poors) 500 includes 500 of the largest companies that are traded on the New York Stock Exchange or NASDAQ. The 500 companies in the index aren’t the 500 biggest companies in the US as there are qualifying conditions to be selected for the index:
The last reason is why Tesla is not listed on the S&P 500. Despite having a market cap of $257.6 billion, which would make them the 14th largest company on the index, they had a bad start to 2019, which recovered in the second half of the year. They may be included in the index after Quarter 2 results come out this month.
The index itself is a market cap weighted index so the bigger the company’s market cap, the bigger the influence it has on the index.
You can see, making an index to follow is quite complex and involves set criteria for most. These companies then sell this information to fund managers such as Vanguard or Blackrock who then copy the stocks and weighting.
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