Index funds part 1: What is a stock market index?

This post is the first in a series of four in which I cover all you need to know about one of the greatest inventions in finance – index funds. See also:

• Index funds part 2: What are index funds?
• Index funds part 3: Why invest in index funds?
• Index funds part 4: How to invest in index funds

Before we can explain what an index fund is, we first need a brief introduction into what a stock is and how stock market indices are calculated.

Stocks and stock prices

A stock is a tiny share of ownership in a business. That is why a unit of stock is also called a share. Let us suppose that a fictional company, the Amazing Biscuit Company (ABC) has 20,000 shares outstanding. Each share, therefore, is ownership of 0.005% of the company. This means that for every share of ABC that you own, you technically own 0.005% of ABC’s assets, both tangible (such as its factories) and intangible (such strong brand loyalty). For every $1,000 in profit that ABC earns, you are entitled to 5 cents of that profit.

Stocks can be traded on stock exchanges, where their prices are determined by buyers and sellers. The price at which buyers want to buy is known as the bid price, while the price at which sellers want to sell is known as the ask price. While the stock exchange is operating (usually office hours from Monday to Friday), there are bid and ask prices for each stock, which originate from buyers and sellers submitting their offers to the stock exchange. The bid price is always lower than the ask price, since if they were equal or if the bid price were higher, then the trades would occur (as the buyer is willing to pay what the seller is asking, and and the seller is willing to accept the price the buyer is proposing, so they will engage in the transaction and their offers will be cleared).

Stock prices are influenced by the financial results of companies such as their revenue, profit, and net assets. While one would expect these numbers to determine the value of the company and therefore the value of each share, price movements in the short-run are determined by the number of buyers and sellers, and how strongly they want to buy or sell. Stay tuned for a future post on what determines the prices of stocks.

The market capitalisation of a company traded on a stock exchange is equal to the number of shares outstanding multiplied by the last traded price of each share. This gives the value of the company as ascribed by participants of the stock market. For example, if the last traded price of an ABC share is $1.00, then the market capitalisation of ABC is $20,000, as there are 20,000 shares outstanding.

Stock market indices

Moving on, a stock market index is a number (usually arbitrary) that tracks the movements of the share prices of a basket of stocks. Now, in addition to the Amazing Biscuit Company (ABC), consider another fictional company, the Defence Company (DEF), listed on the same stock exchange. Suppose that each ABC share is traded at $1.00, and each DEF share is traded at $2.00 today (1 Jan 2021). We can then create a stock market index that is weighted 50% ABC and 50% DEF, which we shall call The ABCDEF Index (TAI). Since the absolute value of stock indices are usually arbitrary, we can set it 100 today, 1 Jan 2021.

The next day, 2 Jan 2021, ABC is trading at $1.50, up $0.50 or 50% from the day prior, as profits were boosted by New Year’s Day revellers gouging themselves on amazing biscuits. However, DEF is now trading at $1.80, down $0.20 or 10% due to a perceived lower likelihood or armed conflict and therefore lower demand for military equipment. We can then calculate TAI for 2 Jan 2021 as 120 (50×0.9+50×1.5). In layman’s terms, since on the previous day, TAI was at 100 with 50% weighting to ABC and 50% weighting on DEF, the change in TAI will be half of the change in ABC (increase of 50%) and half of the change in DEF (decrease of 10%), that is, increase of 25% and decrease of 5%, giving an overall increase of 20%. Note that the weighting of the two stocks in the index has changed – ABC now constitutes 62.5% of TAI, while DEF now constitutes 37.5% of TAI.

	1 Jan 2021	2 Jan 2022
	Share price / index	Percentage weight in index	Share price / index	Percentage weight in index
ABC	$1.00	50%	$1.50	62.5%
DEF	$2.00	50%	$1.80	37.5%
The ABCDEF Index	100	100%	120	100%

So, stock indices track the performance of the share prices of companies constituting the index. In the real world, we use stock indices to tell us about a country or a particular industry. Almost all stock indices these days are market capitalisation-weighted, meaning that the initial weighting of the various companies making up the index is directly proportional to the market capitalisations of each company. This makes intuitive sense, since the stock market index should reflect changes in the share price of bigger companies more significantly than changes in the share price of smaller companies. In our earlier example, we gave ABC and DEF each a weight of 50% in our fictional index, TAI. Suppose the market capitalisation of ABC were $20,000 and the market capitalisation of DEF were $80,000, and we wanted TAI to be market-capitalisation weighted. Then TAI would comprise 20% ABC and 80% DEF, so changes in the price of DEF shares would affect The ABCDEF Index a lot more than changes in the price of ABC shares.

Real-life examples of stock market indices

Some stock indices include:

• Standard and Poor’s 500, or simply S&P 500
  (capitalisation-weighted index of the 500 large companies listed on stock exchanges in the United States);
• Financial Times Stock Exchange 100 Index, or simply FTSE 100 Index
  (free float capitalisation-weighted index of the 100 companies listed on the London Stock Exchange with the highest market capitalisation); and
• Straits Times Index, or simply STI
  (capitalisation-weighted stock market index of the top 30 companies listed on the Singapore Exchange).

(You can click on the links above to view more information on the respective indices.)

These stock market indices are managed and computed by large financial institutions. For example, the Straits Times Index is jointly managed and computed by FTSE Russell, Singapore Press Holdings, and the Singapore Exchange. The five biggest constituents of the STI (out of the thirty) are:
1. DBS Group Holdings;
2. Oversea-Chinese Banking Corporation;
3. United Overseas Bank;
4. Singapore Telecommunications; and
5. Jardine Matheson Holdings.

Why do we need stock market indices?

Why do stock market indices exist? Stock market indices give us information about a country’s economy or a particular sector of it.

Before we explain why, it is natural to ask, what does a company’s stock price tell us? In short, it tells us what people think a company is worth.

Recall that the price at which a company’s stock trades is the price at which buyers are willing to buy and sellers are willing to sell. In other words, it reflects the average price at which buyers and sellers feel the stock is worth. Since market capitalisation is equal to the share price multiplied by the number of shares outstanding, market capitalisation (which is directly proportional to share price) tell us what people think the company is worth. If a share increases in price by 10% over the course of one trading session (that is, the duration the stock market is open in a day), then the market feels that the company is worth 10% at the end of that day than it did in the morning.

Back to the topic of what stock market indices tell us, if we wanted to find out how the value of Singaporean companies has evolved over the past decade, we could select one large company and look at its profits or share price over the past decade. However, there may be many factors affecting that particular company that are unique to it, such as industry dynamics, leadership changes, or sheer luck or lack thereof (such as a factory burning down). It would be difficult to determine the overall performance of Singaporean companies just by looking at one company. The Straits Times Index, in contrast, tells us how the market valuation of the 30 companies in Singapore has changed over time. This gives a better, although imperfect, measurement of the economic machine.

To sum up

• A stock (or share) is a fractional ownership in a company.
• A stock market index tracks the average performance of a basket of stocks.
• Financial institutions manage and compute stock market indices.
• Stock market indices tell us how the value of companies in the economy are changing over time.

In the next article in this series, we will explain what exactly index funds are.