One frequently overhears discussion on how “the market” is doing. But what does “the market” really mean?

The answer depends upon the performance of a particular market index, the first of which originated in 1896 as a collection of twelve publicly traded companies whose values were summed, divided evenly, and tracked over time. This index, the Dow Jones Industrial Average, remains influential to this day, and now includes 30 companies that are summed and divided in a rather more complex manner.

The idea of a market index rapidly evolved. Today, there are thousands of indices to choose from — and nearly as many methodologies by which they’re assembled. That being said, any given index is governed by a strict set of rules and parameters, among which include:

Index Provider
The company or organization responsible for creating the index. S&P Dow Jones, MSCI, and FTSE are the three largest index providers.

Index Objective
The purpose that the index serves. (For instance, measuring the performance of US companies that trade on a US stock exchange.)

Eligibility Criteria
Parameters that determine eligibility for inclusion. (Considerations include the country where a company is headquartered, the stock exchange where it’s listed, its organizational structure, its market capitalization, and so forth.)

Index Construction
The standard by which companies are classified. (Companies on the S&P 500, for instance, are classified according to the Global Industry Classification Standard.)

The rules and processes that determine the ratio of a given constituent to the index as a whole, which include:

  • Weighting Scheme: The denominator by which the ratio of weights are calculated. Schemes include price, market capitalization, and fundamentals.
  • Rebalancing: the frequency (often quarterly) in which weights are recalibrated in accordance with the weighting scheme.

Although every index is calculated differently, they share in common a rules-based system of governance that is often made publicly available. It is through this systematic, rigorous, and transparent methodology that market indexes have gained authority and popularity. They serve as benchmarking tools for investment analysts and as model portfolios for thousands of ETFs and mutual funds.

Further Reading:

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