What is an index?
This article provides an overview of what types of indices there are, what factors are important in calculating an index and what relevance indices have when investing money.
The most important facts in brief
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1. Fundamentals
An index tracks the performance of a group of assets. Typically, indices measure the performance of a basket of stocks designed to track a specific area of the market. This can be a broad-based index that tracks an entire market, such as the Standard & Poor's 500 Index (S&P 500 for short), or more specific indices that track a particular industry or sector (e.g. MSCI Europe Energy or MSCI World Health Care). In general, stock indices are a simple yet useful tool to get information about the situation in a certain economic region or industry. For example, a sustained positive performance of the DAX index can indicate a positive development of the German economy. In addition to share indices, there are also indices for other asset classes, e.g. corporate bonds, government bonds or commodities.
Two of the main criteria of an index are that it is investable and transparent: the methodology of its composition is clearly defined and made publicly available by the respective index provider. Investors cannot invest directly in an index, but they can buy an index fund or an ETF that tracks an index. The performances of an index and index funds/ETFs referenced to it often differ slightly. The difference is called the tracking difference.
2. Best-known indices
Name | Country/Region | Description |
|---|---|---|
MSCI World | Global | The approx. 1,500 largest listed companies by free float* in a total of 23 industrialised countries. |
MSCI Emerging Markets | Global | The approx. 1,400 largest listed companies by free float* in a total of 25 emerging markets. |
MSCI ACWI (All Countries World Index) | Global | Contains all companies from the MSCI World and the MSCI Emerging Markets. |
Dow Jones Industrial Average | USA | 30 large US companies, weighted according to price per share, among others |
S&P 500 | USA | The 500 largest listed US companies by free float*. |
Nasdaq 100 | USA | The 100 largest listed US IT companies by free float*. |
Euro STOXX 50 | Europe | The 50 largest listed European companies by free float*. |
DAX 40 | Germany | The 40 largest listed German companies by free float*. |
FTSE 100 | Great Britain | The 100 largest listed British companies by free float*. |
CAC 40 | France | The 40 largest listed French companies by free float*. |
Nikkei 225 | Japan | The 225 largest listed Japanese companies, weighted by price per share, among others |
CSI 300 | China | The 300 largest listed local Chinese companies (A-shares) by free float*. |
Hang Seng | Hong Kong | The 50 largest companies listed in Hong Kong by free float* (H-shares) |
3. Categories
The decision on which securities to include in an index is made on the basis of various selection criteria.
A benchmark index covers a regional or global market and enables funds to be compared with each other or in relation to other sectors or markets (e.g. S&P 500 or EURO STOXX 50).
A Blue-Chip-Index contains the largest companies in a country, region or even the world (e.g. DAX; tracks the 40 largest listed German companies).
A sector or industry index contains shares that are mainly active in a certain industry (e.g. automobile production or banks).
A strategy index follows a predefined strategy in stock selection (e.g. ShortDAX; reverses the performance of the DAX).
A sustainable index is based on an existing index, but contains only those stocks from the original index that meet certain environmental or social criteria (e.g. DAX ESG).
4. Index calculation
Secondly, it is determined whether the index takes into account only the share prices (price index) or additionally all income from the ownership of the shares (performance index).
In the case of a price index , the index level is determined exclusively on the basis of share prices and is usually only adjusted for income from subscription rights and special payments. Dividend payments and capital changes are not included in the price. This can lead to a price decline on the dividend record date, for example. However, in the case of index funds and ETFs on price indices, dividends are often paid out. Many blue-chip indices, including the Dow Jones, Nikkei 225, FTSE 100 and CAC 40, do not take dividends into account and are therefore price indices.
The performance index (Total Return Index) is calculated as if all dividends and other income from the ownership of the shares, such as subscription rights proceeds, were reinvested in the shares. A distribution or dividend payment therefore has no effect on the price. The DAX and many other indices are calculated as both performance and price indices. The term "DAX" refers to the performance index, whereas internationally, e.g. for the EURO STOXX 50 share index, the term "price index" is usually used.
Thirdly, there are different methods of weighting the components of the index. These are explained in the next section.
5. Weighting of the components
Weighting by price - In a price-weighted index, all components are represented with the same number of shares. The current prices of the shares therefore have a major influence on the weighting of the respective share. Examples of such weighting are the Dow Jones Industrial Average and the Nikkei 225.
Equal weighting - In an equally weighted index, all components are weighted equally regardless of criteria such as market capitalisation, i.e. the performance of each component plays an equal role in the performance of the index. Due to the fact that the market capitalisation of different companies develops differently, the weighting of the individual components must be adjusted regularly in order to ensure a constant equal weighting.
Weighting by market capitalisation - In a market capitalisation weighted index, the weight of a component is calculated by multiplying the current price by the number of shares issued divided by the sum of the market capitalisations of all components of the index.
Free float market capitalisation weighting - In a free float market capitalisation weighted index, the weights are calculated initially as in a market capitalisation weighted index, but are then adjusted for the number of closed or strategically held shares that are not available to the public. These shares can be held, for example, by governments, affiliated companies, founders or employees. Thus, only the freely circulating shares are included in the calculation. This weighting method is the most commonly used method and is applied to the DAX, the S&P 500 and the Nasdaq, among others.
6. Inclusion in an index
For the DAX, for example, a share must be continuously traded on Xetra, Germany's largest trading venue, and its free float must be at least ten per cent in relation to the company's total market capitalisation. In addition, the company must have a registered office in Germany or the focus of its share trading volume on the Xetra trading venue and have a registered office in the EU. The companies that meet these basic requirements are ranked according to their free float market capitalisation. If there is a company that is among the 40 largest companies according to this criterion, it is a DAX candidate. If it is among the 33 largest, it is admitted directly ("Fast Entry"). Otherwise, it is only admitted when another company falls outside of the 46 largest ("Regular Entry"). There are also corresponding rules for regular and fast exit. These rules are intended to prevent too frequent changes in the DAX.
In addition, as a result of the Wirecard scandal, new requirements were introduced in 2020 and 2021 to protect investors. These include the expansion of the index from 30 to 40 members as well as a profitability requirement. In addition, companies can be excluded after a 30-day warning if they do not publish annual and quarterly results audited by an auditing firm.
Adjustments are usually made twice a year in March and September, but may also be made on the extraordinary adjustment dates in June and December.
For the S&P 500, other criteria are also considered. Here, inclusion is subject to a minimum market capitalisation of $8.2 billion and the condition of showing a profit in the quarter before inclusion and an overall profit in the four quarters prior to inclusion. The criteria are regularly reviewed by a panel. The situation is different with the Dow Jones Industrial Average Index, which is also very well-known. The selection of stocks here is solely at the discretion of the publisher, the Wall Street Journal. There are therefore no clear rules as with the DAX or S&P 500, for example. It is recognisable here, however, that companies with a well-known brand and/or a long, successful history tend to be selected.
Stefan Wennemar, CFA
Stefan is a Senior Portfolio Manager in the Wealth Management team. He specialises in portfolio management, data analysis and research on capital market topics. He holds a Bachelor's degree in Economics and Business Administration from Goethe University in Frankfurt and a Master's degree in Finance from the Stockholm School of Economics.
