Diversify your Portfolio with Equity Indices

What is an Index?

Equity Indices provide investors with orientation and overall direction of a specific market or sector. They give them a quick overview of how a region or an industry is performing. In addition, with exchange-traded index funds (ETFs), investors can easily invest in an entire index and thus spread their investment over many different stocks.

An Equity Index tracks the performance of a particular selection of specified shares of listed companies. The best-known Index in South Africa is the JSE Top 40, which tracks the performance of the 40 largest listed companies on the Johannesburg Stock Exchange (JSE). Other well-known European stock indices are the EuroStoxx 50, which contains the 50 largest companies in the Eurozone, the FTSE 100, which consists of the 100 largest British companies; and the CAC 40, which represents the 40 largest French companies. Indices outside Europe are the S&P 500, which includes the 500 largest U.S. companies; the Nikkei 225, which is composed of 225 Japanese companies; and the MSCI World, which provides for more than 1,600 companies from 23 industrialised countries worldwide.

An index is composed of several securities and represents the stock market of a specific country or a specific stock market segment. In addition to stock indices, other indices include commodities, bonds, and currencies, for example.

How is the Index determined?

Index calculations

Indices are calculated according to specific criteria. For example, the JSE Top 40 is a benchmark for the 40 largest companies listed on the JSE. The companies are ranked by market capitalization, a company’s outstanding shares times the current share price. The JSE Top 40 is considered a reliable benchmark for the broader South African stock market because the 40 constituents represent around 80% of the total JSE market capitalization.

There are two different ways of calculating an index. On the one hand, there is the price index, which only considers the prices of the shares. Other return factors, such as dividends, interest, and other income sources, are not considered. On the other hand, there is the performance index (total return index ), which takes into account not only the share prices but also other sources of return, such as dividends.

Index constituents

There are different ways of considering the individual index values for indices. The most common method - as with the JSE Top 40, for example - is to weight the shares according to their market capitalization. The larger the market capitalization, the greater the weighting in the Index.

An older method is to add up the prices of all the shares included in the Index and then divide them by the number of index values. Examples of these are the U.S. Dow Jones index and the Nikkei 225.

Another method is to weigh all the stocks in the Index equally in percentage terms. A regular reset to the original ratio is necessary for this weighting to remain constant over time.

An Index is, therefore, not just an index. Some of the stock market barometers are calculated quite differently. For investors, the weighting of the stocks they contain plays an important role.

What drives the stock indices

One stock market philosophy is that the future is traded on the stock market. This also applies to stock indices. They price the expectations of market participants for the future. But what do expectations depend on? Important factors include:

• Economic news: Central bank announcements, unemployment figures, and economic and political events can drive prices up or down
• Business reports: the performance of stocks also depends on the success or failure of the respective companies. The companies’ annual reports show how much profit or loss is generated. Also crucial to the share price is whether a company exceeds market expectations, which could give the stock a boost, or expectations cannot be met, which could cause share prices to fall.
• Corporate news: Changes within the company’s management, such as the unexpected departure of the CEO, can affect the share price. This also applies to other, yet unknown, events such as acquisitions and mergers with other companies.
• Commodity prices: Various commodities affect the prices of the indices. For example, some of the stocks listed in the FTSE 100 are commodity stocks. Accordingly, fluctuations in the commodity market can affect the index price.

The performance of stock indices depends on economic, political, and, not least, business developments of the companies included in the Index.

Diversification

Whether the value of a stock index rises or falls does not usually depend on a single share; therefore, it is advantageous for investors to spread the risks over different shoulders, i.e., share values, by investing in the entire Index. But here, too, investors should look closely at the relevant indices they find interesting. This applies to the weighting of the stocks included in the Index. If, for example, a stock or a few stocks are weighted particularly heavily because of their large market capitalization, these price fluctuations can significantly impact the entire index value. If, on the other hand, all index stocks are equally weighted, this risk of a uniform price movement of all or most stocks in the Index is avoided. This risk is also referred to as cluster risk. Therefore, looking at the factsheets via the index providers on which the current weightings are documented is obvious.

Conclusion:

• Stock indices serve as stock market barometers against which the developments of corresponding markets, such as countries and industries, can be read.
• · Investors can quickly implement their market expectations with financial instruments such as ETFs, spreading the risks over many stocks