How are indices calculated?

Some share indices are known worldwide, whilst others are at least well-known in their own country. For example, the radio news reports every day on how the Swiss Market Index (SMI) or the Dow Jones in New York has performed. Investors listen closely. Was it a good or a bad day on the stock market?

Indices can make assertions. Whether the index rises or falls on any given day isn’t all that relevant. But the change reveals what the market sentiment was like. For both private and professional investors, indices also serve as a benchmark. They use them to measure how their own portfolio has performed in comparison. And indices are becoming increasingly important thanks to the trend towards passive investment funds such as ETFs.

Who, how, what?

How is an index actually calculated? The first sensible step is to identify a group of equities that have characteristics in common. For example, those operating in the healthcare sector, or the "heaviest" ones – that is, those with the largest market capitalisation (number of equities multiplied by the share price). Take the Swiss Market Index (SMI, established in 1988), for instance: This Swiss index comprises the 20 largest companies whose equities are traded on the Swiss stock exchange. The S&P 500 (whose origins date back to 1923) in the US works in exactly the same way; it comprises the 500 largest US companies. The same applies to the German DAX index (since 1990), which comprises 40 stocks.

However, there would be no such thing as "indexology" – a made-up word, incidentally – if all indices were exactly the same. Most indices reflect changes in share prices and are therefore price indices. The DAX, on the other hand, is a performance index. This means that dividends and their reinvestment are also factored in. This provides a better indication of the returns that investors actually achieve. Nowadays, however, most indices offer both variants, as index data is highly lucrative for providers.

A crucial factor for all indices is the weighting of individual equities. Market capitalisation is not the only factor that counts: most index providers also adjust it. For example, holdings by major shareholders who do not sell – such as founding families – are deducted. This is how the free float is calculated: the portion of equities that is actually available to the public. Furthermore, a stock’s trading volume plays an important role; the higher it is, the better.

A solution for everything

In the Swiss SMI, the pharmaceutical giants Roche and Novartis dominate with weightings of 16.9 per cent and 16.4 per cent respectively. Together with the food multinational Nestlé, the top three equities account for 47.5 per cent. The global equity index also shows a significant imbalance. The MSCI World, which comprises only industrialised countries, consists of more than 70 per cent US equities.

That is the downside when one company or one country is so much larger than the rest. We haven’t mentioned bond indices yet, but the situation is similar there: the more bonds a country has outstanding, for example, the greater its weighting in the index. This applies, for instance, to the euro government bond indices, where Italy and France take up a significant share.

However, index providers have a solution for this too: they calculate variants in which they limit the weighting to 5 per cent or assign equal weighting to all components – known in the jargon as "equal-weight".

Yes, indexology is a bit technical. But simply knowing what you learnt in this introductory lesson helps investors avoid disappointment.

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