Index (Finance)

An index, in finance, is a number that tracks the combined value of a defined group of securities, prices or rates over time. It is calculated under published rules by an index provider, usually starting from a base value such as 100 or 1,000 on a chosen date, so that later readings show how much the group has risen or fallen. Indices exist for shares, bonds, commodities, currencies, property, consumer prices and many other markets.

Investors use indices to gauge how a market is doing, to measure funds against a benchmark, and as the basis for index funds and exchange-traded funds (ETFs). Share indices in particular are covered in the separate entry on the stock market index; this entry deals with the general idea, how indices are built and who builds them. Holding a fund that simply tracks an index is called passive management, which aims to match a market's return at low cost rather than beat it.

Imagine tracking the cost of a weekly shopping basket: bread, milk, eggs and rice. Rather than reporting four prices every week, you could add them up and report one number, then compare it with last week's. That one number is an index of the basket.

A financial index does the same for a basket of investments. Instead of watching 500 share prices, a reader can watch one figure that sums them up. The rules decide what goes in the basket and how much each item counts. Some indices give every item equal say; others let the biggest companies count the most, just as a family spending more on rice than eggs would want rice to matter more in its basket.

The weighting method is the most important design choice, because it decides which members move the index most.

• Price-weighted. Each member counts in proportion to its share price. The Dow Jones Industrial Average (DJIA), first published by Charles Dow in May 1896 with 12 companies and expanded to 30 in 1928, works this way, as does Japan's Nikkei 225.
• Market-capitalisation weighted. Each member counts in proportion to its market capitalisation, usually adjusted to count only shares freely available to trade (free float). The S&P 500, launched on 4 March 1957, and most global indices use this method.
• Equal-weighted. Every member has the same weight at each rebalancing, giving smaller members more influence than in a capitalisation-weighted index.
• Fundamental and factor weighted. Weights based on sales, earnings, dividends or characteristics such as low volatility, used in "smart beta" products.

Indices also differ in how they treat income. A price index tracks only price changes; a total return index assumes dividends or coupons are reinvested, which makes a large difference over long periods.

A price-weighted index divides the sum of member prices by a divisor:

A capitalisation-weighted index divides the total market value of its members by a divisor:

• $P_i$ is the share price of member $i$.
• $Q_i$ is the number of shares counted for member $i$, often adjusted for free float.
• $n$ is the number of members.
• $D$ is the divisor, which the provider adjusts after stock splits, member changes and similar events so the index level does not jump for reasons unrelated to market moves.

Take three shares priced at $50, $100 and $150, with a divisor of 3. The price-weighted index is 300 ÷ 3 = 100. If the $100 share doubles to $200, the index becomes 350 ÷ 3 ≈ 116.7. If instead the $50 share doubled to $100, the index would rise only to 350 ÷ 3 ≈ 116.7 as well, because both moves add $50 to the sum: a price-weighted index cares about dollar changes, not percentage changes or company size. A cap-weighted index would treat those two moves very differently, depending on each company's size.

A few firms dominate index calculation. S&P Dow Jones Indices, formed in 2012 and majority-owned by S&P Global, runs the S&P 500 and the Dow. MSCI runs widely used global and emerging-market indices. FTSE Russell, part of the London Stock Exchange Group (LSEG), runs the FTSE 100 and the Russell US indices. Nasdaq calculates the Nasdaq Composite, launched in February 1971 at a base of 100, and the Nasdaq-100; see Nasdaq. Bloomberg and others produce major bond indices. National exchanges publish local indices such as Pakistan's KSE-100 and various all-share indices.

Providers earn money by licensing their indices to fund managers, exchanges and banks, and by selling data. A committee or rulebook decides membership, typically reviewed on a fixed schedule. When a company joins a major index, funds tracking it must buy, which can move the price, an effect studied since at least the 1980s.

• Market barometer. News reports quote index moves as shorthand for how markets did, and indices define a bull market or bear market.
• Benchmarks. Funds are measured against indices using statistics such as alpha, beta and tracking error.
• Investable products. Index mutual funds, ETFs, futures and options are built on index levels.
• Economic measurement. Indices such as the Consumer Price Index (CPI) track the cost of living and feed into wages, pensions and inflation-linked bonds.

After the manipulation of LIBOR came to light, the International Organization of Securities Commissions (IOSCO) published Principles for Financial Benchmarks in July 2013, covering governance, methodology and accountability. The European Union's Benchmarks Regulation (Regulation (EU) 2016/1011), applying from 1 January 2018, requires administrators of indices used in EU financial products to be authorised or registered, and the United Kingdom kept a similar regime after Brexit under the Financial Conduct Authority (FCA). The United States has no equivalent licensing regime for index providers, although the SEC regulates the funds that track them.

• Regulation (EU) 2016/1011 on benchmarks (EUR-Lex)
• FTSE Russell (London Stock Exchange Group)
• MSCI Indexes