Indexes explained

In short

A friend of mine once asked me why the news keeps saying "the market is up" when his own account sat still. You can clear up that kind of confusion in a few minutes. An index is a list of companies, and a number that tracks how that list is doing. It is a scoreboard, and you cannot buy a scoreboard. If you want what an index does in your own account, you buy a fund that copies the list, and that fund charges a yearly fee. Look up that fee, because it is the one number you control. Check how the index is built, since the same word can mean very different lists. Then compare your results to the right index, not to the headline.

The whole of it

What it is

I once watched an old farmer count his cattle by walking the fence line and tallying heads. He did not count every animal in the county. He counted his own herd and trusted it to tell him how the season was going. An index works the same way. It picks a group of companies, measures their combined value, and turns the result into one number that rises and falls over time.

You have probably heard of the S&P 500, which follows 500 large American companies. You may also know the Dow Jones Industrial Average, which follows just 30. The Nasdaq Composite follows thousands of stocks listed on the Nasdaq exchange. Each one answers a different question. None of them is "the market," though the news talks as if each one were.

Here is a thing worth knowing. An index is only a calculation. Nobody owns it. You cannot walk into a brokerage and buy "the S&P 500" the way you buy a share of a company. What you can buy is a fund, such as an index fund or an exchange traded fund, that holds the same companies the index lists. The fund tries to match the index. The index itself just keeps score.

How it works

Every index has a rulebook. The rulebook says which companies get in, how much weight each one gets, and when the list changes. The weighting is the part that surprises people. Many of the best known indexes use market cap weighting. Market cap, or market capitalization, is the price of one share times the number of shares out there. In a market cap weighted index, a company worth more counts for more. A giant firm moves the number a lot. A small firm barely nudges it.

The Dow does it another way. It is price weighted, so a stock with a high share price pulls harder than one with a low price, no matter how big the company really is. That is an odd rule, but it is the rule, and it explains why the Dow can behave differently from the S&P 500 on the same day.

Then there is the question of dividends. A dividend is a cash payment a company makes to its shareholders. The headline number for an index usually tracks price alone. A total return version of the same index adds the dividends back in. Over many years the gap between the two can be large, so check which one you are looking at.

Most indexes also get reshuffled now and then. Companies grow, shrink, merge, or fade away. A committee or a set of written rules decides who comes in and who goes out. The index you hold today is not the exact list that existed years ago.

The numbers, and where to find yours

If you own an index fund, two numbers matter most. The first is the expense ratio, which is the yearly fee the fund takes, shown as a percent of what you have invested. The second is what the fund actually holds and how closely it tracks its index. Every fund has to publish a prospectus, a plain document that spells out its fees, its goals, and its risks. The Securities and Exchange Commission runs a free search tool called EDGAR where you can pull up any fund's filings by name.

Your own account is the place to look first. Log in, open the fund's page, and find the line marked expense ratio or gross expense ratio. Write it down. The fund company's website will also list the index it follows and how often the list is updated. The index provider, such as S&P Dow Jones Indices, publishes the rulebook, called the methodology, on its own site. It is long, but the first few pages tell you what you need.

If you are comparing a fund to a benchmark, make sure you pick a fair one. A fund of large American stocks should be measured against a large American stock index, not against a global bond index. And remember the fee. A fund will usually trail its index by about the amount of its fee, since the index has no costs and the fund does.

A worked example

Let me tell you about a woman named Dolores. She is 45, and she put 10,000 dollars into an index fund that tracks a large stock index. Her fund charges an expense ratio of 0.10 percent a year. For the sake of the example, say the index earns 7 percent in a year, and her fund matches it before the fee.

The fee on her 10,000 dollars is 10,000 times 0.0010, which equals 10 dollars. Her gain before the fee is 10,000 times 0.07, which equals 700 dollars. After the fee, she keeps 700 minus 10, which is 690 dollars. Her net return is 690 divided by 10,000, or 6.9 percent. That is a tiny gap, and it is why people like low fee funds.

Now picture her neighbor, a man named Walter. He puts the same 10,000 dollars into a fund that charges 1.00 percent. His fee is 10,000 times 0.0100, which equals 100 dollars. His gain before the fee is the same 700 dollars. After the fee he keeps 700 minus 100, which is 600 dollars, a net return of 6.0 percent. The two funds held nearly the same stocks. Walter just paid ninety dollars more for the privilege.

These figures are made up to show the arithmetic. Real returns change every year, and some years they are negative. The point is not the 7 percent. The point is that the fee comes out no matter what the index does.

Where it goes wrong

I have seen smart people trip on this, and it is no shame. The first stumble is thinking an index and a fund are the same thing. They are not. The index is the list. The fund is a product that tries to copy the list, and it has costs the list does not.

The second stumble is trusting the name. Two funds can both say "500" or "total market" and hold different things, weigh them differently, or charge different fees. Read what is inside. A name tells you very little.

The third is chasing the headline. When the news says the market jumped, it usually means one index moved. Your holdings may look nothing like that index. Comparing your account to the wrong yardstick can make you feel better or worse than you should.

The fourth is forgetting that a market cap weighted index can lean hard on a few big names. When a handful of giant companies grow, they take up more of the index. That is how the math works, and you should know it before you assume your money is spread evenly. Look at the fund's top ten holdings, which the fund company publishes, and see for yourself.

The last stumble is ignoring the fee because it looks small. A fraction of a percent sounds like nothing. Yet it comes out every single year, and it comes out of money that would otherwise stay yours. Small things add up. Watch them.

Questions to answer before you leave this page

Do you know which index your fund follows, and could you find its rulebook if you wanted to? Have you looked up your fund's expense ratio, and do you know what it costs you in dollars each year? When you compare your results to a benchmark, is it a fair one for what you actually own? Do you know whether the number you are reading is price only or total return? Have you looked at the top ten holdings, so you know how much rides on just a few companies? And if a friend asked you tomorrow what an index is, could you explain it in a sentence over a cup of coffee?