A stock market index is a method of measuring a stock market as a whole. The market can be Canadian stocks, American stocks, Bio-tech stocks, small-cap stocks, growth stocks, or any other market of interest. Many indices are compiled by news or financial services firms and are used to benchmark the performance of portfolios such as mutual funds.
Types of indices
Stock market indexes may be classed in many ways. A broad-base index represents the performance of a whole stock market — and by proxy, reflects investor sentiment on the state of the economy. The most regularly quoted market indexes are broad-base indexes comprised of the stocks of large companies listed on a nation's largest stock exchanges, such as the American Dow Jones Industrial Average and S&P 500 Index, the British FTSE 100, the French CAC 40, the German DAX, the Japanese Nikkei 225, the Indian Sensex, the Australian All Ordinaries and the Hong Kong Hang Seng Index.
The concept may be extended well beyond an exchange. The Dow Jones Wilshire 5000 Total Stock Market Index, as its name implies, represents the stocks of nearly every publicly traded company in the United States, including all U.S. stocks traded on the New York Stock Exchange (but not ADRs) and most traded on the NASDAQ and American Stock Exchange. Russell Investment Group added to the family of indexes by launching the Russell Global Index.
Weighting
An index may also be classified according to the method used to determine its price. In a Price-weighted index such as the Dow Jones Industrial Average and the NYSE ARCA Tech 100 Index, the price of each component stock is the only consideration when determining the value of the index. Thus, price movement of even a single security will heavily influence the value of the index even though the dollar shift is less significant in a relatively highly valued issue, and moreover ignoring the relative size of the company as a whole. In contrast, a market-value weighted or capitalization-weighted index such as the Hang Seng Index factors in the size of the company. Thus, a relatively small shift in the price of a large company will heavily influence the value of the index. In a market-share weighted index, price is weighted relative to the number of shares, rather than their total value.
Critique of Capitalization-Weighting
The use of capitalization-weighted indexes is often justified by the central conclusion of modern portfolio theory that the optimal investment strategy for any investor is to hold the market portfolio, the capitalization-weighted portfolio of all assets. However, empirical tests conclude that market indexes are not efficient. This can be explained by the fact that these indexes do not include all assets or by the fact that the theory does not hold. The practical conclusion is that using capitalization-weighted portfolios is not necessarily the optimal method.
As a consequence, capitalization weighting has been subject to severe criticism , pointing out that the mechanics of capitalization weighting lead to trend-following strategies that provide an inefficient risk-return trade-off.
Indexes and passive investment management
There has been an accelerating trend in recent decades to create passively managed mutual funds that are based on market indices, known as index funds. Advocates claim that index funds routinely beat a large majority of actively managed mutual funds; one study claimed that over time, the average actively managed fund has returned 1.8% less than the S&P 500 index - a result nearly equal to the average expense ratio of mutual funds (fund expenses are a drag on the funds' return by exactly that ratio). Since index funds attempt to replicate the holdings of an index, they obviate the need for — and thus many costs of — the research entailed in active management, and have a lower "churn" rate (the turnover of securities which lose fund managers' favor and are sold, with the attendant cost of commissions and capital gains taxes).
Ethical stock market indices
A notable specialised index type is those for ethical investing indexes that include only those companies satisfying ecological or social criteria, e.g. those of The Calvert Group, KLD, FTSE4Good Index, Dow Jones Sustainability Index and Wilderhill Clean Energy Index.
Another important trend is strict mechanical criteria for inclusion and exclusion to prevent market manipulation, e.g. in Canada when Nortel was permitted to rise to over 50% of the TSE 300 index value. Ethical indices have a particular interest in mechanical criteria, seeking to avoid accusations of ideological bias in selection, and have pioneered techniques for inclusion and exclusion of stocks based on complex criteria. Another means of mechanical selection is mark-to-future methods that exploit scenarios produced by multiple analysts weighted according to probability, to determine which stocks have become too risky to hold in the index of concern.
Environmental stock market indices
An environmental stock market index aims to provide a quantitative measure of the environmental damage caused by the companies in an index. Indices of this nature face much the same criticism as Ethical indices do — that the 'score' given is partially subjective.
However, whereas 'ethical' issues (for example, does a company use a sweatshop) are largely subjective and difficult to score, an environmental impact is often quantifiable through scientific methods. So it is broadly possible to assign a 'score' to (say) the damage caused by a tonne of mercury dumped into a local river. It is harder to develop a scoring method that can compare different types of pollutant — for example does one hundred tonnes of carbon dioxide emitted to the air cause more or less damage (via climate change) than one tonne of mercury dumped in a river (and poisoning all the fish).
Generally, most environmental economists attempting to create an environmental index would attempt to quantify damage in monetary terms. So one tonne of carbon dioxide might cause $100 worth of damage, whereas one tonne of mercury might cause $50,000 (as it is highly toxic). Companies can therefore be given an 'environmental impact' score, based on the cost they impose on the environment. Quantification of damage in this nature is extremely difficult, as pollutants tend to be market externalities and so have no easily measurable cost by definition.
