MASTERCLASS Investment – What are “Share Market Indices/indexes”?

Investment – What are “Share Market Indices/indexes”?

This month Masterclass Investment looks at what is a share market index (indices plural) – these are values or broad measure summaries of a group of shares, which may be over the whole market in Australia (ASX), or sectors (eg Industrial) and are a means to track changes in stock prices for companies that are in the index/group. So indices frequently provide information about how a group of stocks have performed (of which that index is made up of) – eg S&P 200 is the top 200 stocks by market capitalisation.

Investors use them to provide a benchmark to compare a stock or industry or sector other periods or sectors. Standard & Poor are one of the largest providers of indices which started in USA, but also have offices in 23 countries and create the Australian Stock Exchange Indices. They are calculated to provide investment managers something to measure their portfolio’s performance against – a measure that covers a broad range of Australian shares and includes only shares that are traded in high volume. High volume (liquidity) is important to allow less price distortions arising from a lack of participants in the stock.

The general method of calculation is –

Share Index = Total Market Value of all Companies (in group/sector) / Base Value

Where –

Total market value of all companies = Stock Price x Number of shares available (adjusted)

Base Value = the amount of capital that all the companies had at the time the index was started. The base capital figure is adjusted over time due to changes in the companies in the index.

So the base capital is adjusted when companies in the index;

• Are removed or added;
• Issue more shares;
• Buyback shares;
• Spin-off.

This ensures that the index figure is exactly the same before and after an adjustment above is made in the base capital figure.

Example

BHP is the largest stock in the S&P/ASX200 index. It makes approximately 13.6% of the index.[1]

Imagine if BHP decided to split into many small companies and was no longer allowed to be in the S&P/ASX 200.

Capitalisation alone is not used as it will be a large number and an indexed number is easier to work with and track/graph.

A rise in the share index reveals that the total value of companies in the index rose and a fall in the share index signifies that the total value of companies in the index fell. The index producers also adjust for price changes that usually occur when shares go ex-dividend so that the index figure isn’t affected.

The criteria for when a stock will be included require that it be:

• Listed on the ASX;
  
• Must be a public float of at least 30%;
• Must be actively and regularly traded (liquidity).

Then the market capitalisation of a company is assessed and an average of 6 previous months end-of-day adjusted market capitalisation figures are used. Companies may be removed from an index if they no longer meet these criteria such as when a company significantly changes its structure e.g. merger or acquisition.

In Australia the S&P Australian Index Committee is responsible for maintaining the S&P/ASX indices.

Want to learn the core issues of share investing?

See our slides SMSF & Shares Overview to get a quick session where you can learn to easily understand Company Financial Statements, how to find healthy companies, what Tools and Ratios to use, work on examples, and also includes how to get better investment outcomes.

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