The Wealth Report: A Primer on Market Indexes

Market indexes track the performance of select groups of stocks, bonds or other investments that represent a particular facet of the market, such as government bonds, tech stocks or even the overall equity market.

Overview

In 1993, the Securities and Exchange Commission (SEC) adopted a new rule requiring every open-end management investment company, the entities that manage mutual funds and exchange-traded funds (ETFs), to provide an annual discussion of market factors, industry trends and management tactics that materially affect the fund’s performance each year. Moreover, it required that each fund publish a line graph that compares the fund to an appropriate broad-based securities market index as a benchmark for performance measurement. The graph would assume a $10,000 hypothetical investment and reflect all fund expenses, sales commissions and account fees.¹

A market index is a pool of securities that, in combination, represent a particular sector of the investment market. No one can invest directly in a market index; it is a hypothetical portfolio designed to measure the value of a market segment based on the performance of its underlying securities. In some cases, the value of the index is determined by assigning each security a weight in terms of how much it contributes to the overall worth of the portfolio. Assigned  weights differ among indexes, but may be determined by market capitalization, revenue, floating-rate or real market prices.²

Benchmarks

Even before the SEC ruling, market indexes were used to gauge the path and performance of specific market segments in fund sales and marketing materials. Post implementation, however, indexes became a predominant means for measuring overall price movements in the securities markets. Although you cannot invest directly in an index, they are used as the basis for a parallel portfolio managed passively to directly copy the movements and composition via an index fund. Because index funds are not actively managed, they tend to have lower fees. The first index fund was introduced for individual investors back in 1976 by John Bogle, founder of Vanguard Mutual Funds.³

Index = Diversification

Because each index is comprised of a diverse set of securities, mutual funds and ETFs of similar composition, they also tend to be inherently diversified. Be aware, however, that there are non-diversified funds that may have a smaller number of holdings — although by law no fund can feature holdings with more than 5% of its value in a single company’s stock. Non-diversified funds generally focus on a single industry or geographic sector and are not characterized by the inherent diversification of a market index.⁴ Investment diversification  can be a key strategy because it is able to tap performance of rising stock prices to help counterbalance any declining share prices within the portfolio, thus helping to mitigate overall volatility.

Equity Indexes

There are approximately 5,000 indexes in the U.S. equity market. The Wilshire 5000 is comprised of all publicly traded companies with headquarters in the United States with publicly available price data. However, it is not the most broadly cited index due to its size and span of holdings. Rather, the three most widely followed and quoted indexes are:⁵

1. DJIA — The oldest and best-known index in the world, the Dow Jones Industrial Average is comprised of 30 of the largest capitalized (large cap) and most dominant (blue-chip) companies in the United States. It is a price-weighted index, meaning that higher-priced stocks have a greater influence on the portfolio’s overall return. The DJIA accounts for about 25% of the entire U.S. stock market’s value and is well represented by high-dividend paying companies.
2. S&P 500 — The Standard & Poor’s 500 Index is made up of 500 of the top companies in the United States. It represents about 80% of the total U.S. stock market’s worth and is market-weighted so that every stock is represented in proportion to its total market capitalization. The S&P 500 is widely considered a solid indicator of activity in the American markets.
3. Nasdaq — The Nasdaq Composite is a market-capitalization-weighted index. While it is known for being heavily represented by technology companies, it also includes securities from other industries (e.g., financials, industrials, insurance and transportation) and even companies not based in the United States. However, due to its tech tilt, it is considered a viable measure of tech industry performance, including speculative holdings with small market capitalizations.

“An index is not an investment in and of itself. It’s a measure of performance for a certain set of securities. It’s a sampling. Index funds will invest in the same securities as the underlying benchmark index.”⁶

Sector indexes represent stock holdings that share a specific security characteristic or asset class, such as small cap value or dividend growth. Investors may choose to use market index funds to invest in emerging growth sectors or niches within certain sectors (e.g, renewables within the energy industry).

Final Thoughts¹⁰

Clearly, there are a lot of market indexes. They demonstrate how much expertise goes into tracking and benchmarking various investment opportunities. There are analysts who specialize exclusively in one area of the market and spend their days researching, interviewing and “kicking the tires” of companies included in that market segment. There is an awful lot of analysis that goes into determining whether a company’s share price will rise or fall.

All of this information is aggregated via indexes to make it easier for brokers, advisors and investors to track and evaluate market movements. Indexes also make it convenient to build a portfolio with diversified exposure to a specific market of interest, using comparable benchmark values to gauge the investment’s performance.

In fact, these days it’s even easier to get diversified exposure to certain market segments via index-aligned mutual funds or ETFs. You can even combine them to create a strategic asset allocation designed to meet your long-term goals.

The point is, there is a lot of variance in index investment strategies for how to choose your investments. Choosing your investments goes beyond simply defining your financial goals, timeline and risk tolerance. Your financial professional can help you choose what segments of the market are best suited to meet your objectives and help you stay on track by comparing them to the indexes aligned with your investments.

This content is provided for informational purposes. It is not intended to be used as the sole basis for financial decisions, nor should it be construed as advice designed to meet the particular needs of an individual’s situation. None of the information contained herein shall constitute an offer to sell or solicit any offer to buy a security. Individuals are encouraged to consult with a qualified professional before making any decisions about their personal situation. The information and opinions contained herein provided by third parties have been obtained from sources believed to be reliable, but accuracy and completeness cannot be guaranteed by AE Wealth Management. Neither AEWM nor the firm providing you with this report are affiliated with or endorsed by the U.S. government or any governmental agency. Investing involves risk, including the potential loss of principal. No investment strategy can guarantee a profit or protect against loss in periods of declining values. AE Wealth Management, LLC (“AEWM”) is an SEC Registered Investment Adviser (RIA) located in Topeka, Kansas. Registration does not denote any level of skill or qualification. The advisory firm providing you this report is an independent financial services firm and is not an affiliate company of AE Wealth Management, LLC. AEWM works with a variety of independent advisors. Some of the advisors are Investment Adviser Representatives (IAR) who provide investment advisory services through AEWM. Some of the advisors are Registered Investment Advisers providing investment advisory services that incorporate some of the products available through AEWM. Information regarding the RIA offering the investment advisory services can be found at https://brokercheck.finra.org/.

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