"The S&P 500 is at its all-time high", "the BEL 20 reaches 4,000 points", "the Nikkei 225 loses 20% after Fukushima" ... Behind these Breaking News lies the notion of index, a central concept in finance which highlights a financial trend at a glance. In a nutshell, an index is a financial measure that allows an investor to swiftly evaluate the performance of a defined set of financial instruments. It generally covers a stock exchange, a geographical area or a given sector. If the financial assets considered are most often equities, there are also bond and derivatives indices.
An index is a basket (a set) of a given number of assets meeting predefined criteria. The respective weightings of these securities in the index are generally set according to their market capitalization and capped to avoid overrepresentation. As an example, the BEL 20 takes over the 20 most important companies listed on the Euronext Brussels stock exchange and limits their weight to 15%. A large company like AB Inbev therefore has a greater weight (~ 12%) within BEL 20 than a more modest company like Colruyt (~ 2%).
The index is a virtual measure whose absolute value has no direct link with the market capitalization of its constituents and has no other value than to serve as a basis for calculation. Only the differential observed during a given period is important. This is calculated as the weighted average of the individual performances of the constituents. This average gives the upward or downward trend of the basket as a whole.
The notion of index dates back to 1896 when Charles Dow, editor of the Wall Street Journal, sought to offer his readers a quick and easy way to gauge the performance of the New York Stock Exchange. He had the idea to calculate a value representing the average performance of the 12 largest listed industrial stocks on Wall Street. This is how the first stock index was created. Charles Dow modestly named it the Dow Jones Industrial Average.
It was not until the 80s that the Dow Jones inspired other indices around the world. In the early 90s, each stock exchange had its own index represented by an acronym followed by a figure reflecting number of constituents. These indices were then calculated and published by financial newspapers or stockbrokers' associations. The best known are the BEL 20 in Brussels, the CAC 40 in Paris, the S&P 500 in the United States and the Nikkei 225 in Tokyo.
If indices were initially virtual values with sole purpose to indicate a trend, investors quickly found it useful to use them as a basis of comparison, or benchmark, to assess the performance of a portfolio. Thanks to indices, an investor could easily judge the investment decisions of his wealth manager.
In the late 80s, a large US bank (State Street) had the idea to create a fund replicating the composition of the S&P 500 to offer its investors exactly the performance of the index. The first index fund, the SPY, was born. This made the indices emerge, no longer as indicators or comparators, but as the very basis for developing investment strategies. Given the difficulties experienced by active managers in doing better than the indices, these funds soon became very successful. Today, the SPY is the largest fund in the world with $250bn of invested assets.
The development of index funds and derivatives stimulated the creation of new indices. The advent of computing accelerated this growth even further by facilitating their calculation up to a point where the value of indices could be determined in real time. Sector, region, size, currencies, societal impact ... are some of criteria used to define the new baskets of assets. The growth was so fulgurant that there are today more than 3 million indices worldwide.
An index is often perceived as passive and static. However, it is a dynamic measure whose weighting is adjusted daily according to the evolution of the stock exchanges and whose constituents are periodically re-evaluated, the fallen angel companies being replaced by the rising stars. As a result, General Electric is the only stock still part of the Dow Jones a century later, and the largest company of BEL 20 in 2007, Fortis, is no longer part of it today.
If indices offer a quick way to understand the evolution of a market, precipitation leads to misinterpretation. The most frequent error factors arise from the fact that the most common indices exclude dividends and are expressed in local currency.
When excluding dividends, an investor analysing the performance of the CAC 40 will think that the Paris stock exchange has not yet recovered from the 2008 crisis. However, when including the large dividends paid by French companies, one realizes that the CAC 40 has erased its losses since 2015.
Similarly, ignoring the currency effect, we would lead one to think that Wall Street has done much better than Paris in 2017, with 19% for the S&P 500 against 9% for the CAC 40. However, given the depreciation of the dollar over the period, the S&P 500's appreciation was actually limited to 5% in euros, which is two times less than the Paris stock market.
The indices are the basis of the investment approach implemented by easyvest. Indices made it possible to highlight the inefficiency of active management and are also at the origin of the development of index funds, the financial instruments recommended by easyvest. Our investment solutions allow you to benefit from the power indices through index funds. Our private advisors are always available to help you build customized investment portfolios tailored to your life projects.
Note: This article was written when Easyvest was authorized and regulated by the FSMA as an agent in banking and investment services.