5.6 Stock Indexes & Averages

When people ask how the market did today, they usually mean how an index moved. A stock index tracks the value of a defined group of stocks, and the way it is built determines what it tells you.

What Indexes Are Used For

• Market barometer: a quick measure of how the market or a sector performed.
• Benchmark: a standard against which to judge a portfolio manager or fund.
• Basis for products: index mutual funds, ETFs, futures and options track or are based on indexes.
• Risk measurement: a stock's beta is measured against a market index.
• Economic indicator: stock indexes are leading indicators of the economy.

How Indexes Are Constructed

Worked Example: Same Move, Different Results

An index has three stocks:

Case 1: Stock A rises 10% to $110.

• Price-weighted average: $(100 + 50 + 10)/3 = 53.33$ becomes $(110 + 50 + 10)/3 = 56.67$, a gain of 6.25%.
• Market-cap-weighted: total value rises from $4.0 billion to $4.1 billion, a gain of 2.5%.

Case 2: Stock C rises 10% to $11 instead.

• Price-weighted: $(100 + 50 + 11)/3 = 53.67$, a gain of only 0.63%.
• Market-cap-weighted: total value again rises to $4.1 billion, a gain of 2.5%.

In a price-weighted index, the high-priced stock dominates even though it is not the largest company. In a cap-weighted index, a 10% move in two companies of equal size has the same effect regardless of share price. A stock split changes a price-weighted index's arithmetic, so its divisor must be adjusted; a cap-weighted index is unaffected by splits.

Index Maintenance and the Divisor

Index providers maintain their indexes so they continue to measure the market fairly:

• Divisor adjustments: when a company in a price-weighted average splits its stock, the divisor is lowered so the split does not change the average's value. Cap-weighted indexes adjust their divisors for share issues, buybacks and changes in constituents.
• Additions and deletions: S&P Dow Jones Indices reviews the S&P/TSX indexes regularly, adding companies that meet its size and liquidity rules and removing those that no longer qualify.
• Float adjustment: shares held by control blocks, governments or strategic owners are excluded, so a company's weight reflects only the shares available to investors.

Index changes can move prices. When a stock is added to a major index, the index funds and ETFs that track it must buy, which often increases demand for the shares around the effective date.

Biases to Keep in Mind

A cap-weighted index automatically gives larger weights to stocks that have risen, so it can become concentrated in a few large companies or one sector. Equal-weighted indexes avoid that concentration but tilt toward smaller companies and need frequent rebalancing, which raises trading costs for the funds that track them.

Price Index vs. Total Return Index

A price index reflects only price changes. A total return index assumes dividends are reinvested. Over long periods the difference is large, especially in a dividend-rich market such as Canada, so benchmarks for funds should be total return indexes. Structured products that pay the price return of an index exclude dividends.

Canadian Indexes

U.S. and Global Indexes

• Dow Jones Industrial Average: 30 large U.S. companies, price-weighted, the oldest widely quoted average.
• S&P 500: 500 large U.S. companies, float-adjusted cap-weighted, the main U.S. benchmark.
• Nasdaq Composite: all common stocks listed on Nasdaq, technology-heavy.
• MSCI EAFE and MSCI World: developed markets outside North America, and developed markets worldwide.

Because the S&P/TSX Composite is concentrated in a few sectors and the S&P 500 is heavy in technology, a Canadian investor who holds only the domestic index takes significant sector risk. Global indexes show how much diversification foreign markets can add.