How Does a Stock Index Work?
The underlying holdings in an index are commonly referred to as the index’s “basket of stocks.” For example, 30 of the largest U.S. companies are included in the Dow Jones Industrial Average (DJIA) Index’s basket of stocks. The movement of those 30 stocks in the basket affects the index’s performance. An investor who wants to add exposure to large-cap U.S. stocks can use the Dow as a guide for which stocks to pick. Similarly, the Philadelphia Gold and Silver Index (XAU) consists of companies that mine gold and other precious metals. If you buy the stocks in the index, you will gain balanced exposure to the gold mining sector without having to buy shares in every single gold mining company in the world. The shares in the XAU aim to be representative of the gold mining industry as a whole.
Index-Weighting
While an index may contain hundreds or even thousands of stocks, they aren’t all included equally. Index-weighting refers to the method of how the shares in an index basket are allocated. In other words, an index’s weighting is how the index is designed. For example, a price-weighted index buys shares in proportion to the cost of those shares. A stock priced at $20 might have one share included in the index, whereas a stock trading at $5 would have four shares included. The most typical weighting strategy is based on market capitalization. The shares of each stock in a cap-weighted index are based on the total market value of the company’s outstanding shares. A market-cap-weighted index includes more shares of companies that are worth more, and fewer shares of smaller companies.
Alternatives to Replicating Indexes in Your Portfolio
While you can individually buy all the stocks in an index, there’s an easier way to add index exposure. Mutual funds and exchange traded funds (ETFs) track indexes. These products essentially lower the barriers to entry to buying these indexes. Rather than saving up the money needed to buy one share of every stock listed on an index, an investor can obtain the same diversification by buying a single share in a mutual fund or ETF that tracks that index. While ETFs, like any investment, come with certain disadvantages, there are also advantages to ETFs that have helped them become incredibly popular. In 2021, ETF assets under management amounted to more than $10 trillion. One advantage is that ETFs enjoy certain tax advantages over the mutual funds that track the same index.
Pros and Cons of Stock Indexes
Pros Explained
Indexes simplify the research process: Indexes do the heavy lifting for investors who want to learn about how an industry, economy, or sector is performing. Instead of having to find relevant companies and study their performance on an individual basis, investors can instead watch a single index.Indexes allow investors to gain exposure to commodities: Depending on the sector being tracked by the index, buying indexes may be the only option for an average investor looking to expose themselves to certain markets. For example, not everyone has the space to store barrels of oil, herds of cattle, or bags of wheat. Instead, these investors can buy the appropriate commodity index that tracks the market they want to buy into.Index ETFs and mutual funds make it easy to diversify: Index funds are an easy way to gain exposure to certain markets or sectors without having to place thousands of orders.
Cons Explained
Indexes aren’t always accurate: While an index is designed to emulate a certain market, that doesn’t mean it’s 100% accurate. Just because you buy a foreign market index in a certain region, it doesn’t mean your basket will perfectly reflect the economy of that region. Many factors can alter the course of an economy, and sometimes it’s difficult for an index to accurately account for all of those factors. Indexes aren’t always liquid: It may be difficult to trade in and out of certain positions, depending on the index you track. If you’re trading an obscure index, it may be difficult to find a person willing to buy or sell the security you want to trade. However, this isn’t an issue with many indexes that consistently see high daily trading volumes. Other trading issues still apply: All the downsides that come with other forms of investing also apply to index investing. That includes issues related to order type—market orders will execute quickly but they won’t guarantee a price, while limit orders control the price at the cost of timeliness.
Stock Index vs. Stock Exchange
For example, consider Nasdaq, which is a stock exchange in New York City that traders and other professionals can visit in person. Thousands of stocks are traded on the Nasdaq exchange. Those stocks can be indexed, such as with the Nasdaq Composite index, so that an analyst can track the performance of stocks on the Nasdaq exchange. Indexes can also get more specific, like the Nasdaq-100 Index (NDX), which tracks the largest 100 non-financial companies traded at the Nasdaq exchange.
