Composite Index Explained
Many investors tend to compare their portfolio earnings to a popular index. A well-diversified portfolio can often outperform these indexes. However, it’s easier said than done. Many of them are comprised of some of the biggest multi-national companies in the world. Later, we will take a look at a few examples of indexes. While some investors aim to create their own portfolio, others spread their funds across a few indexes. This is a good long-term strategy to avoid headaches and minimize volatility. Let’s look at a composite index.
What Is a Composite Index?
The majority of investors are aware of the Dow Jones Industrial Average (DJIA). This composite index was created in 1896 by the founder of the Wall Street Journal, Charles Dow.
He realized that the biggest companies on the stock market often moved in the same direction. He decided to group them.
Today, there are over 5000 composite indexes based on sectors, industries, market cap and other characteristics that bring them together.
The goal is to have a general idea of how certain pieces of the stock market are performing against their counterparts.
Each composite index weighs its stocks differently. This means that the percentage of each security’s weight in the index is calculated differently. Below are the popular weighing methods.
Popular Weighing Methods
Let’s look at how a Composite Index weighs it’s stocks.
Market-cap-weighted: Stocks with a bigger market cap weigh more in the index as opposed to smaller cap stocks. In this case, the market cap of each stock is taken as a percentage of the total market cap which includes all the companies.
Price-weighted: Stocks with a higher price weigh more than cheaper stocks. As ridiculous as this sounds, one of the most popular indexes is price-weighted. Nowadays, the price of a stock means almost nothing.
Apple’s (NASDAQ: AAPL) stock price is $156.57 with a market cap of $2.555T. The most expensive stock in the world is Berkshire Hathaway (NYSE: BRK.A). The price is just under $500,000, but the market cap is significantly lower than Apple’s at $731.19B. The price of a stock isn’t a reliable measure.
Fundamental-weighted: The weight in the index is determined by fundamentals such as earnings, cash flow, sales etc. This method became popular in the last decades.
Equal-weighted: Every company has the same weight regardless of market cap, price or fundamentals.
In the next section, we will take a look at the most popular indexes and how to invest in them in the stock market. Many funds follow their weighting and try to replicate their performance and holdings with a few changes.
Types of Composite Indexes & How to Invest in Them
We probably now want to know what types of a composite index there is an how you can invest in them. There have to be more than one right? You’re correct. Let’s read more about them.
Standard & Poor’s 500 Index (S&P 500)
The S&P 500 index in a composite index and is market-cap-weighted. It is considered as one of the best benchmarks of the US stock market. It is comprised of the 500 biggest companies by market capitalization and other factors.
The S&P website only shows the top 10 holdings. The entire list isn’t available, but we can deduce the majority of its holdings. The total market cap of the S&P 500 was $42.4T in January 2022.
Apple’s market cap is $2.56T. Apple’s weight on the index is 6%. To invest in the S&P 500, it is necessary to do so with an ETF. There isn’t any shortage of companies following one of the most popular indexes. Below is a list of the most popular.
SPDR S&P 500 ETF Trust (NYSEARCA: SPY). This is the largest ETF in the world.
iShares Core S&P 500 ETF (NYSEARCA: IVV)
Vanguard 500 Index Fund ETF (NYSEARCA: VOO)
SPDR Portfolio S&P 500 ETF (NYSEARCA: SPLG)
ProShares Ultra S&P 500 (NYSEARCA: SSO)
Dow Jones Industrial Average (DJIA)
Remember the price-weighted index? This is another composite index. Today, it’s comprised of 30 ‘’trendy” blue-chip companies. When it was first created, it included only 12. Over time, the companies that form this index change.
Today, the index includes the following: 3M, American Express, Amgen, Apple, Boeing, Caterpillar, Chevron, Cisco Systems, Coca-Cola, Dow Inc, Goldman Sachs, Home Depot, Honeywell, IBM, Intel, Johnson & Johnson, JPMorgan Chase, McDonald’s, Merck & Co, Microsoft, Nike, Proctor & Gamble, Salesforce, The Travelers Company, UnitedHealth Group, Verizon, Visa, Walmart, Walgreens Boots Alliance and Walt Disney.
The DJIA does not represent the overall performance of the US economy. The sample size is too small and does not adequately represent every industry. It also neglects smaller-cap companies. They are an important part of our economy. Unlike the S&P, there is only one fund replicating its performance.
SPDR Dow Jones Industrial Average ETF Trust (NYSEARCA: DIA)
The Nasdaq Composite
We jump from one of the smallest indexes to one of the broadest. The Nasdaq Composite Index comprises 3000 stocks, American Depository Receipts (ADRs), Real Estate Investment Trusts (REITs) and other securities listed on the NASDAQ exchange. ETFs are excluded. It is also market-cap-weighted. Below is a breakdown of all industries included in the Nasdaq Composite.
Consumer services: 16.09%
Consumer goods: 8.51%
Health care: 7.70%
Oil and gas: 0.8%
Basic materials: 0.44%
The tech industry had some trouble since the beginning of the year. The current administration is trying to restrict tech companies’ power and growth. Furthermore, some are having issues on their own. Netflix (NASDAQ: NFLX) and Facebook (NASDAQ: FB) are both losing users on their platforms. They are expecting some roadblocks in the next quarters. Since the tech industry weights a lot in the Nasdaq Composite, the other industries aren’t well represented when they are experiencing growth.
There are a few ETFs that have a similar breakdown to the Nasdaq Composite index.
Invesco QQQ Trust Series 1 (NASDAQ: QQQ)
Invesco Nasdaq 100 ETF (NASDAQ: QQQM)
Fidelity Nasdaq Composite Index ETF (NASDAQ: ONEQ)
Other Composite Indexes
We saw the 3 most popular indexes on the US stock market. There are more that follow companies based on their market capitalization, industry and more. Every country with a stock market has their set of indexes. In the UK, the top 100 stocks are indexed in the CBOE 100 UK. China, Japan, South Korea, Russia, Europe and other big markets also have their own versions.
Some indexes comprise a large number of stocks, similar to the Nasdaq Composite. However, they have a fairer distribution between industries. The Russell 2000, Russell 3000 and the Wilshire 5000 are good examples. They try to give us a look at the economy as a whole.
One last interesting index is the VIX. It represents the expectation of volatility in the next 30 days on the market as a whole. Basically, VIX measures the level of fear, stress and anxiety the market is feeling. Investors seeking an inverse index, here you go. This one is very volatile and has a few ETFs replicating its performance as well.
Barclays iPath Series B S&P 500 VIX Short-Term Futures ETN (BATS: VXX)
ProShares Vix Short-Term Futures ETF (BATS: VIXY)
ProShares Vix Mid-Term Futures ETF (BATS: VIXM)
Now You Know What a Composite Index Is
To conclude, composite indexes give us a broad view of various components of the stock market. They give us the big picture on an industry, on the NYSE and the NASDAQ or on the stock market as a whole.
For investors, indexes are simple ways to invest their money without having to pick individual stocks. The top 3 composite indexes, the S&P 500, the DJIA and the Nasdaq Composite, are very good options for long-term growth. Each country has its own set of indexes.
If you want to learn more about how you can profit from the stock market, head on over to our free library of educational courses. We have something for everyone, including trading options for those with small accounts.