Understanding How Indices Measure Market Performance
A security market index is a single number that represents the performance of a group of securities (the constituent securities). It acts as a barometer for a specific market, market segment, or asset class.
The value of an index and its return can be calculated in two primary ways, depending on whether income distributions are included.
Reflects only the changes in the prices of the constituent securities. It does not account for dividends or interest payments.
Measures the total performance by tracking both price changes and the reinvestment of all income (dividends and interest) received from the constituent securities. A total return index will always outperform its corresponding price index over time.
Illustrative Example: Single-Period Return
An index starts the period at a value of 1,000. During the period, the prices of its constituent stocks rise, bringing the price index value to 1,020. The stocks also pay dividends, which, if reinvested, would bring the total return index value to 1,025.
To calculate the index value over multiple periods, you geometrically link the returns from each period.
Where V_T is the value at the end of period T, V₀ is the initial value, and R is the return for each period.
Constructing an index involves two key steps: selecting the target market and securities, and choosing a weighting method.
| Weighting Method | Description | Example | Pros & Cons |
|---|---|---|---|
| Price-Weighted | Constituents are weighted by their absolute share price. | Dow Jones Industrial Average | Pros: Simple to calculate. Cons: Biased by high-priced stocks; distorted by stock splits. |
| Equal-Weighted | Each constituent has the same weight in the index. | Value Line Index | Pros: Diversified; avoids large-cap dominance. Cons: Biased toward small-caps; requires frequent rebalancing. |
| Market Capitalization-Weighted | Constituents are weighted by their total market value (Share Price × Shares Outstanding). | S&P 500 | Pros: Represents the market proportionally. Cons: Biased toward large-cap, overvalued stocks. |
| Float-Adjusted Market Cap-Weighted | Like market-cap weighted, but uses only the number of publicly available shares (the "float"). | FTSE 100 | Pros: Focuses on the investable portion of the market. Cons: Similar biases as standard market-cap weighting. |
| Fundamental-Weighted | Constituents are weighted by a fundamental metric like revenue, earnings, or cash flow. | N/A (Various) | Pros: Avoids large-cap bias; aligns with value investing. Cons: Requires more data; may not track market trends. |
This is the process of adjusting the weights of the constituent securities to maintain consistency with the index's weighting methodology. For example, an equal-weighted index must be rebalanced periodically as stock prices change and the weights drift. This process incurs transaction costs.
This is the process of changing the constituent securities in an index. Securities are added or removed to ensure the index remains representative of its target market. This is a subset of the broader rebalancing process and often causes the prices of added securities to rise and removed securities to fall around the announcement date.
These are more challenging to construct than equity indices due to the vast and dynamic universe of bonds and the reliance on dealer pricing.
Based on futures contracts; returns include price changes, collateral yield, and roll yield.
Include appraisal-based, repeat sales, and REIT indices.
Track performance of hedge funds but are subject to biases like survivorship bias (failing funds drop out, inflating average returns).