The stock indices are used as a thermometer to determine the health of a given financial market over a period of time. The Ibex 35, the Euro Stoxx 50, the Dow Jones, etc., are stock market indices that allow us to know – in aggregate form – the behavior of a set of actions that are grouped according to certain criteria, such as the geographical area or the sector of activity to which they belong.
We can define the stock market indices as indicators that try to reflect the evolution of the prices of the listed securities that are grouped in each one of them, that is, they offer a numerical value that is calculated according to the values that compose it, to which attributes a certain weight to them.
Thus, we have to know that there are weighted indexes – the vast majority – in which each value is weighted by its market capitalization, as is the case of the S&P 500, among others, in which the most capitalized securities have a greater weight. ; others in which, in addition, the free float is taken into account, which is the capital that is freely quoted without being in the hands of reference shareholders, as is the case of the Ibex 35, and others in which it is weighted according to the price of each value, as it happens with the Dow Jones of Industrials.
On the other hand, although they are not so common, we have to talk about the unweighted indices such as, for example, the Nasaq 100 Equal Index, in which all the values that compose it have the same weight, so that each company influences the same mean when calculating the performance of the index.
In addition, if we look at the composition of the indices by the titles they include, we not only find stock indices, such as those mentioned above, but we also have fixed-income indices, such as the AIAF 2000, for Spanish fixed-income, or the Bloomberg Barclays Global Aggregate Index, which invests in different fixed income assets around the world and, also, in derivatives such as CFDs (contracts for difference) on indices.
What are stock indices for?
Stock indices have several functions, the first of which is to serve as a reference to know the market sentiment in a given country, geographic area or sector.
Stock indices are often used as underlyings, so they serve as a reference to measure the evolution of a certain product, such as investment funds. In this way, they are used as reference indices or benchmarks, which serve both active management -the manager builds his portfolio using a certain index as a reference- and the individual investor, who can see how his investment fund is behaving with respect to at that benchmark. This serves to compare returns and see if the fund manager is providing alpha -ability that has to generate value against market behavior- or not.
In passive management, the indices are taken as a reference so that it replicates, thus imitating their positions and, also, their profitability.
How are they classified?
From the Dow Jones Industrial Average, which is the oldest index in the world – it is 123 years old – and brings together the 30 most important industrial companies in the United States, up to our selective Spanish company, the Ibex 35, we can talk about different indices as we classify them.
If we attend to its issuers, we can speak of indices that belong to organisms dependent on official exchanges or indices of private entities. In the first case, we find indices like the Ibex and in the second, indices like the S&P 500.
If we look at the origin of the securities, we can speak of national indices, which bring together shares that are listed in the same country -German data or the CAC 40 in Paris- and global indices, formed by the shares of companies that belong to more from a country or to several continents, such as the MSCI World or the Euro Stoxx 50. If we look at the activity of companies, we can speak of sector indices such as the Nasdaq Composite or the Euro Stoxx Banks.