From the March 01, 2010 issue of Futures Magazine • Subscribe!

Equity indexes: A guide for beginners

TOP DOMESTIC INDEXES

The equity index with the best name recognition is no doubt the Dow Jones Industrial Average. In addition to being the best-known barometer of the stock market, the Dow is the oldest price measure in the United States. Established in 1886 with 11 companies, it was increased to the 30 in 1928. These 30 large-capitalization, blue chip stocks cover nine economic sectors, including financial services, technology, retail, entertainment and consumer goods. They represent about 20% of the market value of all U.S. equities. The Dow shows how these companies trade during a session of the stock market. It is an average share price that is price-weighted and scaled. To calculate the Dow, the prices of all 30 stocks are summed and divided by a divisor. The divisor is adjusted to compensate for the effects of corporate financial actions.

The Standard & Poor’s 500 (S&P 500) is the most widely followed after the Dow and is the broad market barometer for investors. This free-float capitalization-weighted index is considered a bellwether for the American economy and is included in the Index of Leading Indicators. It contains 500 actively traded, large-capitalization common stocks that are selected by a committee. The committee chooses companies that are representative of U.S. industry, trade publicly and are sufficiently liquid. To keep the index comparable over time, a divisor is used to adjust for any corporate financial actions. While the S&P 500 began in 1957, it has been linked to an earlier S&P index (S&P 90), which has extended it back to 1928 on a daily basis and to 1871 on a monthly basis.

The Nasdaq 100 combines 100 of the largest domestic and international companies listed on the Nasdaq Exchange. It is a modified market capitalization index. The companies’ weights are based on their market capitalizations, with certain rules capping the influence of the largest components. The index contains no financial companies, but does include companies that are incorporated outside of the United States. Created by Nasdaq on Jan. 31, 1985, it includes industrial, technology, retail, telecommunications, biotechnology, health care, transportation, media and service companies. The index’s composition changes when companies are delisted, but it is only rebalanced once a year. Each December, Nasdaq reviews its components, re-ranks all eligible companies and makes the appropriate adjustments.

The Russell 2000 index includes the bottom 2,000 stocks in the Russell 3000 index. It is the most widely accepted measure of small cap stocks trading in the United States — 99% of all small cap institutional assets are benchmarked to the Russell indexes. On the other hand, the Russell 1000 index is comprised of the largest 1,000 companies and represents approximately 92% of the U.S. market. The Russell indexes are rules-based in their construction and composition. There are no committees or editorial boards involved in the process. The indexes are reconstituted annually, with new entries, specifically initial public offerings added quarterly. In 1994, Russell pioneered the use of free float rather than total shares outstanding.

These four indexes allow traders to hedge a particular risk and can be used in tandem to make particular bets on what sectors are leading or lagging.

INTERNATIONAL INDEXES

Compagnie des Agents de Change (CAC 40)
This is a float-weighted index of the prices of 40 French shares, which started in December of 1987. The shares in the index are drawn from the 100 largest French companies. CAC-40, a subset of the larger SBF (Societe des Bourse Francais) 250, has been published by the Paris Bourse since June 15, 1988. It is recalculated every 30 seconds.

Deutscher Aktien IndeX (DAX)
This is a market value-weighted index of the 30 largest German companies that account for more than 65% of turnover on the Frankfurt Stock Exchange. The index has been computed since Dec. 30, 1987 and is recomputed every minute by the exchange’s electronic system, Xetra. Stocks are reviewed quarterly.

Dow Jones EURO STOXX 50
The DJ EURO STOXX 50 is Europe’s leading blue chip index for the Eurozone. It provides a representation of “super sector” leaders from Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal and Spain. Introduced on Feb. 26, 1998, data is available daily back to 1986. The index captures 60% of the free-float capitalization of the Dow Jones EURO STOXX Total Market Index, which covers 95% of the free-float capitalization of the represented countries.

FTSE 100
FTSE Group, the result of a joint venture between the Financial Times and the London Stock Exchange, maintains this index. Initiated on Jan. 3, 1984, it consists of 100 UK companies with market capitalization that accounts for more than 85% of the total market capitalization of the London Stock Exchange. Calculated in real time and published every 15 seconds, the index is an arithmetic weighted index. Member companies are determined on a quarterly basis.

Korea Composite Stock Price Index (Kospi)
The KOSPI 200 is one of a series of indexes based on the common stocks traded on the Stock Market Division of the Korea Exchange. Introduced in 1983, KOSPI is calculated based on market capitalization. The KOSPI 200, which includes the top 200 publicly traded stocks in the index, maps over 70% of the market’s total capitalization. The KOSPI 200 option contract has ranked number one in volume in the world since 2002.

Nikkei 225
This is a price-weighted arithmetic index of 225 blue chip Japanese companies in the First Section (large companies) on the Tokyo Stock Exchange. It began to be calculated on Sep. 7, 1950, and was retroactively calculated back to May 16, 1949. Similar to the Dow, the Nikkei is used as a major indicator for the Japanese economy. Unlike the Dow, it is designed to reflect the overall market, so there is no specific weighting of industries. Components are reviewed annually. Changes usually are made at the beginning of October, but they can take place at any time a stock is found to be ineligible. After a stock is replaced, the divisor is reviewed and modified to ensure a smooth transition.

Russian Trading System (RTS)
The RTS Index is the composite index of the Russian stock market calculated by the “Russian Trading System” Stock Exchange. It contains 50 preferred and common shares that are capitalization-weighted with free-float coefficients. First calculated on Sep. 1, 1955, it is now calculated every 15 seconds. Constituents are selected by a Committee on the basis of the companies’ capitalization, liquidity and industry type. The constituent lists are reviewed every three months.

Tel Aviv-25
The TA-25 index is the Tel Aviv Stock Exchange’s flagship index. It was first published under the name of MA’OF Index. Initiated on Jan. 1, 1992, the index tracks the prices of shares of the 25 companies with the highest market capitalization on the exchange. The weight of each stock is calculated on a quarterly basis.

Tokyo stock Price IndeX
The Tokyo stock Price IndeX (Topix), along with the Nikkei 225, is a family of stock indexes from the First Section of the Tokyo Stock Exchange. There are approximately 1,700 constituents in the index. Calculated as of Jan. 4, 1968, the index reflects movements in the Japanese economy. In 2006, the index completed a transition from a float weighting system to a free-float system.

If you trade stock indexes based on technical measures, it may not be necessary to know all of the specific details of how they are built and how they are adjusted, but an index is a measure of numerous inputs and how they relate to each other is a measure of what they are made of. It is good to know what you are trading. Knowing what an index is made of and how it is made is similar to knowing how a rainy May in Iowa may affect corn prices. Markets move on information, and the more information you have, the better your chances of success.

Laura Oatney is a freelance writer with more than 20 years of industry experience. Contact her at loatney@yahoo.com .

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