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Investing In Index Funds

A popular vehicle for investing in the stock market is an index fund. Index funds allow an investor to own a collection of stocks that is designed to track a specific market index. One such popular index is the S&P 500 Index and the Nasdaq Composite Index.

When you invest in an index as opposed to an individual stock, you are stating that you want to own a broader portion of the stocks that are comprised of that index. For the S&P 500, you are essentially owning a piece of Corporate America versus owning a single company such as Apple (AAPL).

When you own one share of an index fund such as SPY, you effectively are investing in the 500 large-and mid-cap U.S stocks.

U.S Index Funds

In this article, we will focus on U.S. Index Funds where their adoption and popularity for investing has grown over the years. In fact, indexes are so widespread that there is literally an index fund for every financial market. The media most often reports on the direction of the top three indexes regularly throughout the day with key news items serving as contributors and detractors. Additionally, investment managers use indexes as benchmarks for performance reporting.

Meanwhile, investors of all types use indexes as performance proxies and allocation guides. Indexes also form the basis for passive index investing often done primarily through exchange-traded funds that track indexes specifically.

An understanding of how market indexes are constructed and utilized can help to add meaning and clarity for a wide variety of investing avenues. Below, we elaborate on some of the most followed U.S. indexes. Below is an image from BarChart showing the performance of the 3 major U.S. index funds for the year 2019 to 2020.

S&P 500

The Standard & Poor's 500 Index (known commonly as the S&P 500) is an index with 500 of the top companies in the U.S. Stocks are chosen for the index primarily by capitalization but the constituent committee also considers other factors including liquidity, public float, sector classification, financial viability, and trading history. The S&P 500 Index represents approximately 80% of the total value of the U.S. stock market. In general, the S&P 500 Index gives a good indication of movement in the U.S. market as a whole.

Indexes are usually market-weighted or price-weighted. The S&P 500 Index is a market-weighted index (also referred to as capitalization-weighted). In other words, if the total market value of all 500 companies in the S&P 500 drops by 10%, the value of the index also drops by 10%.

The Dow Jones Industrial Average

The Dow Jones Industrial Average (DJIA) is one of the oldest, most well-known, and most frequently used indexes in the world. It includes the stocks of 30 of the largest and most influential companies in the United States. The DJIA is a price-weighted index. It was originally computed by totaling the per-share price of the stocks of each company in the index and dividing this sum by the number of companies. Unfortunately, the index is no longer this simple to calculate.

Over the years, stock splits, spin-offs, and other events have resulted in changes in the divisor (a numerical value computed by Dow Jones used to calculate the level of the DJIA) making it a very small number (less than 0.2). In general, the Dow is known for its listing of the U.S. markets best blue-chip companies with regularly consistent dividends. So while not necessarily a representation of the broad market, it can be a representation of the blue-chip, dividend-value market.

Nasdaq Composite Index

The Nasdaq Composite is an exchange whose composition is weighted towards technology-based companies. According to Investopedia (Investopedia Nasdaq Composite), more than 45% of the securities within the Nasdaq comprises of technology companies. The remainder are consumer services, healthcare, financials, etc.

Investors can also see securities from just a number of industries, including investment, manufacturing, insurance, and transport reserves, among others. Nasdaq 100 is made up of big and medium businesses, and unlike Dow and S&P 500, it also features most financial stocks with low market capitalizations. As a result, its movements usually indicate the efficiency of the technology sector as well as the attitudes of shareholders towards more speculative stocks.

Russell 2000 Index

The Russell 2000 index is on the other corner of the spectrum. It tracks the performance of approximately 2000 United States small-cap companies. The Russell 2000 Index is part of the larger 3000 small-cap companies found in the Russell 3000 index. Russell 3000 covers nearly 98% of the United States publicly listed stocks.

Both Russell 2000 and the S&P 500 index are market-cap-weighted. However, unlike the S&P 500 index, the stocks in the Russell 2000 index are not chosen by a panel but rather by a calculation terms of the market size and present participation in the index.

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Investing in Index Funds