What is an index: S&P 500, FTSE 100 and Nasdaq
Learning objectives
Explain what a stock index measures and how weighting determines its behaviour
Describe what the major indices actually contain and which economies they represent
Recognise why concentration means a "diversified" index can be a narrow bet
How an index is built
An index is a single number summarising the value of a group of shares. Trade one and you're taking a position on that group's collective direction rather than on any individual company. What matters is which group, and how the number is calculated.
Two decisions define any index: which companies are in it, and how much each one counts.
Selection is usually by size and by listing venue, applied through published rules and reviewed periodically. Companies enter and leave as they grow, shrink or move.
Weighting is where indices diverge, and it matters far more than most people realise.
Market capitalisation weighting is the standard. Each company counts in proportion to its total market value, so the largest companies dominate. The S&P 500, Nasdaq 100 and FTSE 100 all work this way.
Price weighting counts each company in proportion to its share price rather than its size, which produces some odd results: a smaller company with a high share price can outweigh a much larger one with a low share price. The Dow Jones Industrial Average is the notable survivor of this approach, which is why it's less representative than its fame suggests.
The concentration problem
Here's the thing that surprises people about market-cap weighting.
An index containing 500 companies sounds diversified. If a handful of very large companies account for a substantial share of total market value, the index's daily movement is driven by that handful, and the remaining hundreds contribute very little.
This has become significant in US indices, where the largest technology companies have grown to represent a large proportion of the S&P 500's total value. A position in a broad US index is, in practice, substantially a position in a small number of megacap technology stocks.
That doesn't make it a bad instrument. It makes "diversified" a claim worth checking rather than assuming, and it explains why the S&P 500 and Nasdaq 100 now move together far more closely than their different constituent counts would suggest.
Check the current top ten holdings and their combined weight before you assume an index is broad. Both are published.
The major indices
S&P 500. Five hundred large US companies, market-cap weighted. The standard benchmark for US equities and probably the most widely tracked index in the world. Broad sector coverage on paper, heavily concentrated in technology in practice.
Nasdaq 100. The largest non-financial companies listed on the Nasdaq exchange. Technology-dominated by construction, since that's what lists there. More volatile than the S&P 500 and far more sensitive to interest rate expectations, for reasons What moves index markets explains.
Dow Jones Industrial Average. Thirty large US companies, price weighted. Famous, historically important, and the least representative of the US market of the three. Its fame comes from its age rather than its methodology.
FTSE 100. The hundred largest companies on the London Stock Exchange. Heavily weighted toward energy, mining, financials and consumer staples rather than technology. Critically, a large majority of FTSE 100 revenues are earned outside the UK, which means a weaker pound tends to lift the index by making those overseas earnings worth more in sterling. The FTSE 100 is a poor proxy for the UK economy and a decent proxy for global commodities and a weak pound.
DAX 40. Germany's largest listed companies, industrial and export-heavy. Worth knowing that the headline DAX is a performance index that includes reinvested dividends, unlike most major indices which are price indices. That makes its long-run chart look better than a like-for-like comparison would.
Nikkei 225 and Hang Seng. Japan and Hong Kong respectively, and the main routes to Asian equity exposure on most retail platforms.
What an index actually tells you
Each of these answers a different question, and choosing the wrong one means expressing a view you didn't intend.
- A view on US large-cap growth and technology points to the Nasdaq 100, or the S&P 500 with the concentration caveat above.
- A view on global commodity prices or sterling weakness points to the FTSE 100, which is not the same as a view on Britain.
- A view on European industrial activity and exports points to the DAX.
The name tells you where a company is listed. It doesn't tell you where it earns its money, and for index trading the second matters more.
Why trade an index rather than a stock
Three reasons, from The instrument map: forex, stocks, indices, commodities, metals, crypto CFDs.
Single-company risk is diluted. One firm's scandal, fraud or disastrous earnings barely moves a market-cap-weighted basket, subject to the concentration caveat.
Gap risk is lower. Individual shares gap violently over earnings. An index containing hundreds of companies reporting on different dates doesn't experience the same discontinuity.
The drivers are macro. Interest rate expectations, growth and risk sentiment, which are the same forces covered in the Fundamental Analysis course. If you've learned why a rate decision moves a currency, you already understand most of why it moves an index.
Key takeaways
An index summarises a group of shares into one number. Selection sets what's in it and weighting sets what actually drives it
Market-cap weighting means a few very large companies can dominate an index of hundreds, so a broad index can be a narrow bet on megacap technology
The FTSE 100 earns most of its revenue abroad, so it tends to rise on a weaker pound and is a poor proxy for the UK economy
The name tells you where companies are listed, not where they earn. For index trading, the second matters more