What is an index?

The concept of an index easily explained

An index is a securities basket representing a whole market or a submarket. It tracks the performance of this market and serves as a benchmark for investors or fund managers.

For example, the UK stock index FTSE 100 contains the stocks of the 100 largest and most liquid UK-listed companies.

In addition to equity indices, there are also indices on bonds, commodities or real estate.

In most cases, indices are offered and calculated by large stock exchanges, independent index providers or rating agencies. The most popular index providers are MSCI, S&P, STOXX and FTSE.
 

Index as a measure for markets

What is an index?
 

Securities selection in a stock index

Each index is based on fixed rules, which determine which securities are included in the basket. In the case of stock indices, the rules are particularly often based on the following two properties:
 
  • Stock exchange, on which a company is listed
  • Size of the company (market capitalization)
For example, the FTSE 100 index represents the 100 largest and most liquid UK companies listed on the London Stock Exchange.

In addition, there are many other rules, by which the securities could be selected in an index. For example, the index could contain only companies from certain industries, such as finance, energy or real estate. This allows investors to track the performance of individual sectors in a market.

 

Securities weighting in an index

In the index rules, the index provider also determines how the weights of the individual companies in the index are determined. This is also known as index weighting.

Most common indices are market cap weighted. In this case, the index weights the individual companies according to their size. Thus, the largest company has the largest weight in the index.
 
Definition of market capitalisation (stock market value):
Total value of shares of a listed company.
Price * Number of free-float shares outstanding.
The company's own stock is not included in the calculation. This is also known as free float market capitalisation.
The FTSE 100 is also weighted by market cap. Only the freely tradable shares, also know as free float, are relevant. This excludes locked-in shares such as shares held by governments, insiders or others.The resulting market capitalisation is smaller than what would result from a full-market capitalisation method.

Other methods are equally weighted, price weighted or weighted by fundamental selection criteria such as dividend yield. These methods are dealt with in more detailed articles.

 

Index rebalancing: Re-adjustment of the index

In the case of market cap weighted indices market movements ensure that the weight of the securities in the index changes over time: if the share price of a company increases, its weight in the index also rises.

Indices are not static. For this reason, a regular check of the components takes place at fixed time intervals determined in the index rules. This is also called index rebalancing in the specialist jargon. Companies can leave an index and be replaced by new companies.

In the case of the FTSE 100 Index, the composition and weighting are reviewed on a quarterly basis. Changes happen, for example, when the 100th largest company is "overtaken" by the 101st largest. Then the previously larger company falls out in favor of the new one.

In practice, entire index families have established themselves, since one can divide the world according to a certain schema. Among the most well-known are the MSCI indices.

The following table provides a brief and rough classification of well-known indexes.
Index Short description Weighting method Cheapest ETF
by TER
Number of
ETFs
FTSE MIB 40 largest Italian companies Free float market cap weighted from 0.33% p.a. 3
DAX 30 largest German companies Free float market cap weighted from 0.09% p.a. 4
EURO STOXX 50 50 largest European companies Free float market cap weighted from 0.05% p.a. 9
MSCI World appr. 1.600 largest companies from developed markets worldwide Free float market cap weighted from 0.15% p.a. 11
S&P 500 500 largest US companies Free float market cap weighted from 0.05% p.a. 11
Dow Jones
Industrial Average
30 of the largest US companies Price weighted from 0.33% p.a. 2
Nikkei 225 225 of the largest Japanese companies Price weighted from 0.09% p.a. 2

For an excursion into the world of different indices, we recommend our ETF investment guides. Here you will find the most important indices for various investment themes.
 
 

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