An index is a collection of stocks that showcase the overall performance of a specific sector, or the market overall. You cannot buy shares of an index directly as they are more of a thermometer for market performance. However, you can buy an index ETF or trade index options.
Even if you do not invest in an index, you can gauge the performance of your own portfolio by comparing it to a given index’s performance. These measures are often referred to when assessing the impact of significant world events – if any of the major indices drops significantly, it makes headlines.
Popular Indices
The Dow Jones Industrial Average has been around for more than 100 years and it’s still popular today. More commonly known simply as the “Dow”, it was originally designed to observe railroad and transportation companies. The Dow now tracks 30 companies that best represent the American Economy. The 30 stocks chosen are picked by a selection committee. The Dow uses a price weighting, so every dollar movement of one of the 30 stocks moves the Dow Index by a dollar.
The most popular index today is the S&P 500, a collection of the 500 largest American companies. A company’s size is measured based on their market capitalization, which is their share price multiplied by their number of shares. The S&P 500 is more commonly observed today than the Dow because of how broad it is. However, the index price uses market cap weighting instead of the Dow price weighting. This means companies with a larger market cap will have a greater impact on its price than smaller companies.
Canadian Index
The most popular Canadian index is the S&P/TSX Composite Index. This tracks roughly 220 of the largest Canadian companies based on market capitalization. The market cap of these 220 companies make up roughly 75% of the entire market cap of the Toronto Stock Exchange, therefore it is considered a good representation of the Canadian stock market.
If you’re interested in looking at a more focused group of companies, the S&P/TSX 60 narrows it down to the largest 60 companies.
Investing in an Index
While you are not able to buy shares of an index directly, there are ways around this. The most popular method is investing in an ETF that tracks an index. There are many different companies that offer index ETFs who compete with each other and offer different management fees. These ETFs strive to mimic the index so that it invests in all of the stocks at the exact same weighting as the index. If you’re looking to diversify your account with limited effort or management, you can benefit from index ETFs, since they tend to be broadly diversified and have low management fees.
For option traders, index options are a way to predict the direction an index price will go by an expiry date. Since you cannot purchase shares of an index, all index options are cash-settled, meaning the difference between the strike price and the index price on expiry is transferred between the option buyer and seller. Index options can only be exercised on the expiry date unlike traditional equity based options that can be exercised at any time.
Summary
An index is a benchmark that monitors how the market is performing. When a monumental event occurs, news reports will often refer to an index to quickly gauge how much of an impact the event had on the market. It can also be used by investors to determine if their personal investments are performing better or worse than an index. Investing directly in an index is not possible, but there are alternatives, such as index ETF and index options.
