A stock market index is a performance tracker of a collection of shares representing a specific segment of the financial markets. They can be designed to follow a particular industry, heed to a specific investing style, or encapsulate large portions of the overall stock market.

In the United Kingdom, the FTSE 100 is often considered the gold standard as a proxy for the British economy. Whereas in the United States, the S&P 500 is the most popular benchmark index.

How can investors use a stock market index?

Investors can use stock market indices for a variety of purposes. Some of the most common include:

• Tracking Market Sentiment – Investors can review trends in popular indices to gain insight into how positive or negative investor sentiment currently is. Comparing the 200-day and 50-day moving averages is a common technique used by traders to see which direction stock prices are likely to move in the short-to-medium term.
• An Investment – Investors cannot directly invest in an index. However, it’s possible to buy shares in an index fund that replicates the hypothetical portfolio of an index. By doing this, investors will be able to replicate the performance of the underlying index. And since the fund manager handles all the portfolio rebalancing, this approach essentially puts an investment portfolio on autopilot.
• Performance Benchmark – Some investors prefer to build a custom portfolio by picking individual stocks. And often, these individuals will want to compare their returns against a suitable index. After all, if a custom portfolio is struggling to keep up or surpass a stock market index, it may be prudent for the investor to change their investment strategy.
• Calculating Expected Returns – Knowing the average rate of return delivered by an index over a specific period can help investors be more realistic with their personal return expectations. This can help lead to better financial planning for the future.
• Calculating Beta – Beta represents the volatility of a stock relative to a stock market index. And one of the most popular methods of estimating Beta is by running a linear regression between stock price percentage return against an index’s percentage returns.

How to analyse a stock market index

While stock market indices are relatively simple financial instruments, they have a few characteristics that can complicate things. Let’s go through the steps investors need to take when trying to analyse or understand an index and how they are designed to work.

1. Check what the index tracks

When searching for an index, investors need to make sure they select an appropriate one. For example, let’s say an investor wants to compare the performance of their custom renewable energy stocks portfolio.

They could opt to use the FTSE 100 like most investors. However, given the level of concentration within the energy sector, it will likely be more meaningful to compare performance against an energy index.

2. Check what companies are inside the index

After creating a list of seemingly suitable stock market indices, an investor may find value in looking closer at which companies are in the index being considered. Some indices have eligibility requirements, such as a minimum market capitalisation.

If the investor’s renewable energy portfolio predominantly consists of risky small-cap stocks, using an energy index that requires its constituents to have a large market cap will likely be unsuitable.

3. Check how the index is weighted

Every index assigns weightings to each of its constituent stocks. And depending on the method used, some stocks may have a larger influence on the index’s performance than others.

Some of the most common index weighting methods include:

• Market Capitalisation Weighted – The companies within the index with the largest market capitalisation have a greater weighting than those with smaller valuations. This means large-cap stocks have more influence on the performance of an index than smaller-cap ones.
• Float-Adjusted Market Capitalisation Weighted – Index constituents are weighted the same way as the market capitalisation weighted method. However, the market caps of each stock are adjusted to remove the effects of non-investable shares. As such, any shares held by controlling investors or government institutions are excluded. The FTSE 100 and S&P 500 are both examples of a float-adjusted market cap-weighted index.
• Price-Weighted – The companies within an index are weighted based on their share price. Therefore, stocks that trade at a higher stock price have more influence on the index’s performance than shares trading at low prices. Note that market capitalisation does not have any impact on the weighting decision. Even if a company has a market cap of $1trn, it may still have a lower weighting than a $50bn firm if the share price is trading lower. The Dow Jones Industrial Average is an example of a price-weighted index.
• Equal-Weighted – Every index constituent has the same weighting regardless of market cap or stock price.
• Volume-Weighted – The weighting of index constituents is determined by how frequently their shares are being traded. The companies with a higher average trading volume will receive the greatest weighting.
• Fundamental Weighting – The weight of each stock in an index is determined based on some fundamental metric, such as revenue, earnings, cash flow, or book value. The firms with the highest fundamental values will have the highest weighting.

Leading UK stock indices

The list of UK stock market indices is long. However, some of the most popular indices used as benchmarks include:

• FTSE 100 – The stock market index tracks the performance of the largest 100 UK stocks by market cap.
• FTSE 250 – This stock market index tracks the performance of the 101st to the 250th largest UK stocks by market cap.
• FTSE 350 – This index comprises both FTSE 100 and FTSE 250 companies. Investing in an index tracking its performance provides another alternative.
• FTSE AIM 100 – This index includes the largest 100 UK stocks by market capitalisation, which have their primary listing on the Alternative Investment Market (AIM).
• FTSE All-Share – An index that contains all the listed companies on the main London Stock Exchange.

Leading US stock indices

Multiple US stock market indices are quoted regularly within financial media and the investing community. Some of the most popular include:

• S&P 500 – This stock market index tracks the performance of a total of 500 large companies listed on stock exchanges in the United States.
• Dow Jones Industrial Average – Contains 30 of the most prominent publically traded businesses in the United States.
• Nasdaq 100 – This index consists of the 100 largest and most actively traded listed companies on the Nasdaq Stock Exchange.
• Russell 2000 – A market cap index that measures the performance of the 2,000 smaller companies listed in the United States.

How to invest in a stock market index?

As previously mentioned, a stock market index is not a tradable financial security. It’s merely a hypothetical portfolio designed to track specific industries or sections of the stock market. As such, investing in an index is not actually possible.

However, investors can replicate an index’s performance with a low-cost index fund. We’ve written a complete beginner’s guide to investing in an index fund. However, the process can be briefly summarised into three primary steps.

1. Choose an Index
2. Pick an Appropriate Fund
3. Buy Shares in the Fund.

The bottom line

Stock market indices can be a useful tool for performance benchmarking as well as for more advanced investing computations. Understanding how they function and the roles they play can help investors discover new investment opportunities.

This article contains general educational information only. It does not take into account the personal financial situation of the reader. Tax treatment is dependent on individual circumstances that may change in the future, and this article does not constitute any form of tax advice. Before committing to any investment decision, an investor must consider their individual financial circumstances and reach out to an independent financial advisor if necessary.