As we covered in our last piece, indices have their place. They can roughly gauge the mood of a market and its participants. If you have an investment strategy designed to capture that market, you can see how your strategy is doing in comparison … again, roughly. You can also invest in an index fund which tracks a market index.
This may help explain why everyone seems to be forever watching, analyzing and talking about the most popular indices and their every move. But you may still have questions about what they are and how they really work. When you hear the term “stock index,” you’re in good company if the first thing that comes to mind is the S&P 500; some of the world’s largest index funds are named after it. We’ll talk more about index investing in our next piece, but we’ll note here that, despite its familiarity, the S&P 500 is a babe in the woods compared to the world’s first index. That honor goes to the Dow.
The Grand Old Dow
As described in “Capital Ideas” by Peter Bernstein:
“The first Dow Jones Average appeared in the Afternoon News Letter on July 3, 1884. It consisted of the closing prices of eleven companies: nine railroads and two industrials. [Charles] Dow’s idea was to provide an overall measure of the performance of active companies, at a time when an average day’s activity on the New York Stock Exchange was about 250,000 shares.”
Eleven companies, nine of them railroads, wouldn’t make for much of a market proxy these days! And yet the Dow still only tracks 30 stocks, as it has since 1928. Plus, it still uses mostly the same methods for tracking them. As expressed by James Mackintosh, a senior market columnist for The Wall Street Journal (the effective birthplace of the Dow): “It’s time to ditch the Dow. After 120 years, the venerable Dow Jones Industrial Average is an embarrassing anachronism, abandoned by professionals and beloved only by a media that mostly knows no better.
For example, when the Dow Jones Industrial Average (the Dow) exceeded 20,000 points last January and then broke 21,000 just over a month later; what are those points even measuring and is it relevant? Checking an index like the Dow at any given time is like dipping your toe in the water to see how the ocean is doing. You may have good reasons to do that toe-check, but as with any approximation, be careful to not misinterpret what you’re measuring. Otherwise, you may succumb to misperceptions like: “The Dow is so high, it must be in for a fall. I’d better get out.”
And yet, despite its flaws, the Dow persists. Markets are made of people, and people can be sentimental about their past. More pragmatically, the Dow serves as a time capsule of sorts, offering historical perspective no other index can match. It’s also just plain familiar. As its parent company the S&P Dow Jones Indices says, “It is understandable to most people.” We would argue it needs to be updated or, better, replaced.” With that in mind, when it comes to index points, we’d like to make a few points of our own.
Indices Are Often Arbitrary
It helps to recognize how current indices became popular to begin with. In our free markets, competitive forces are free to introduce new and different structures, to see how they fly. In the same way that the markets “decided” that the iPhone would prevail over the Blackberry, popular appeal is effectively how the world accepts or rejects one index over another. Sometimes the best index wins and becomes an accepted reference. Sometimes not.
Different indices can be structured very differently. That’s why the Dow recently topped 20,000, while the S&P 500 is hovering in the 2,000s, even though both are often used to gauge the same U.S. stock market. The Dow arrives at its overall average by adding up the price-weighted prices of the 30 securities it’s tracking and dividing the total by a proprietary “Dow divisor.” The S&P 500 also takes the sum of the approximately 500 securities it’s tracking … but weighted by market cap and divided by its own proprietary divisor.
Think of index points as being like thermometer degrees. Most of us can’t explain exactly how a degree is calculated, but we know hot from cold. We also know that Fahrenheit and Celsius both tell us what the temperature is, in different ways.
Same thing with indices. You can’t directly compare an S&P 500 point to a Dow point; it doesn’t compute. Moreover, neither index adjusts for inflation, while under-performing companies are periodically removed and replaced by better performing companies. So, while index values offer a relative sense of how “hot” or “cold” a market is feeling at the moment, they can’t necessarily tell you whether a market is too hot or too cold, or help you precisely predict when it’s time to buy or sell into or out of them. The “compared to what?” factor is missing from the equation. This brings us to our third point …
Models Are Approximate
There’s an important difference between hard sciences like thermodynamics and market measures like indices. On a thermometer, a degree is a degree. With market indices, those points are based on an approximation of actual market performance – in other words, on a model.
A model is a fake copy of reality, with some copies rendered considerably better than others. Here’s what Nobel Laureate Eugene Fama has said about them: “No model is ever strictly true. The real criterion should be: Do I know more about markets when I’m finished than I did when I started?”
How Do Indices Get Built?
What about all those other indices? New ones come along whenever an indexer devises a supposedly better mousetrap for tracking market performance. If enough participants accept the new method, an index is born. That’s our free markets at work; sounds simple enough. But if we take a closer look at the various ways indexers track their slices of the market, what may seem clear at a glance is often seething with complexities just under the surface. Here are some (not all!) of the ways various indices are sliced and diced.
How much weight should an index give to each of its holdings? For example, in the S&P 500, should the returns delivered by Emerson Electric Company hold the same significance as those from Apple Inc.?
- The Dow is price-weighted, giving each company more or less weight based on its higher or lower share price. As Mackintosh explained, “share prices are arbitrary, as they depend on how many shares are issued; some companies have very high prices, which give them more influence on the Dow, even though they may be less valuable overall.”
- Market-cap weighting is the most common weighting used by the most familiar indices around the globe. It factors in outstanding shares as well as current share price to give more weight to the bigger players and less to the smaller companies.
- Some indices are equal-weighted, giving each holding, large or small, equal importance in the final tally. For example, there’s an equal-weighted version of the S&P 500, in which each company is weighted at 0.2% of the index total, rebalanced quarterly.
There are many other variations on these themes. The point is, indices using different weightings can reach significantly different conclusions about the performance of the same market slice.
Widely Inclusive or Highly Representative?
How many individual securities does an index need to track to correctly reflect its target market?
- As we mentioned above, the Dow uses 30 securities to represent thousands of publicly traded U.S. stocks. A throw-back to simpler times, it’s unlikely you’ll see other popular indices built on such modest samples. In its defense, the Dow favors stocks that are heavily and frequently traded, so prices are timely and real … at least for the 30 stocks it’s tracking.
- At the other end of the spectrum, the Wilshire 5000 Total Market Index “contains all U.S.-headquartered equity securities with readily available price data.”
- The S&P 500 falls somewhere in between, tracking around (not always precisely) 500 largest publicly traded U.S. securities.
Tracking a Narrow Slice or a Mixed Bag?
What makes up “a market,” anyway? Consider these possibilities:
- If an index is tracking the U.S. market, should that include real estate companies too?
- If its make-up tends to include a heavier allocation to, say, value versus growth stocks, how does that influence its relative results … and is it a deliberate or accidental tilt?
- Is an index broadly covering diverse sectors (such as representative industries or regions) or is its focus intentionally concentrated?
- If it’s tracking bonds, are they corporate and municipal bonds, short term or long term, or just one or the other?
The Use and Abuse of Indexing
How well do you really know what your index is up to? Remember, in Part I of this series, we described how every index is a model – imperfect by definition. How might each index’s inevitable idiosyncrasies be influencing the accuracy of its outcomes?
According to Professor Fama’s description of a model, indices have long served as handy proxies to help us explore what is going on in particular slices of our capital markets. However, they also can do damage to your investment experience if you misinterpret what they mean. We’ve just touched on a few of the questions an indexer must address. Like the proverbial onion, many more layers could be peeled away and the deeper you go, the finer the nuances become.
For now, remember this: An index’s popular appeal is the result of often-arbitrary group consensus that can reflect both rational reasoning and random behavioral bias. Structures vary, and accuracy is (at best) approximate. Even the most familiar indices can contain some surprising structural secrets. One practical conclusion is that some indices are much easier to translate into investable index funds than others. In addition, some lend themselves better than others to a sound, evidence-based investment strategy. In fact, indices often may not be the ideal solution for that higher goal to begin with. In our next and final segment, we’ll explore the strengths and weaknesses inherent to index investing.
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