Share Market Indices Explained: What Does A Market Index Mean?

A beginner’s guide to understanding share market indices

What is a share market index?

Why are share market indices created?

How are share market indices created/calculated?

What does the market index number actually mean?

Why use an index number?

What does a change in the share index mean?

What can be included in a share market index?

Why are stocks removed from a share market index?

Who maintains a share market index?

 What is a share market index?

A share market index tracks changes in stock prices for companies in the index. Share market indices are frequently quoted to provide information about how a group of stocks have performed.

 Why are share market indices created?

Standards and Poor’s states that the S&P/ASX200 exists to meet the “needs of investment managers who require a portfolio benchmark and index characterized by sufficient size and liquidity”. [1]

What they mean is that investment managers need something to measure their portfolio’s performance against. They need 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 because it means there are less price distortions in the price arising from a lack of participants in the stock.

 How are share market indices created/calculated?

A share market index is quoted as a seemingly arbitrary number. E.g. ‘the S&P/ASX 200 closed at 4,653.3 today’.

 What does the market index number actually mean?

“The level of an index reflects the total market value of all the component stocks relative to a particular base period… On any given day, the index value is the quotient of the total available market capitalization of the index’s constituents and its divisor.”[2]

Share Index = Total Market Value of All Companies / Base Value

Total market value of a company = Stock Price x Number of shares available (adjusted)

Base Value

Base capital value reflects the amount of capital that all companies had at the time the index was started. The base capital figure is adjusted through time due to changes in the companies in the index. The base capital is adjusted when companies in the index;

  • are removed or added
  • issue more shares
  • buyback shares
  • spin-off

The index maintainers will ensure that the index figure is exactly the same before and after an adjustment is made in the base capital figure. This ensures that the index does change due to a company issuing more shares or buying shares back.

If the base capital figure weren’t adjusted share indices wouldn’t be a true reflection of how the market has performed.

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.

The total market capitalisation of all companies in the S&P/ASX 200 would fall dramatically. If the index maintainers did not adjust the base capital amount, the S&P/ASX 200 would show a dramatic drop. The drop would not reflect the true performance of the Australian stock exchange and many portfolio managers could claim a return well above the benchmark!

 Why use an index number not just the market capitalisation value?

If the index just represents the value of all companies in the index why not just use the value figure rather than an index number?

“An indexed number is used to represent the results… in order to make the value easier to work with and track over time. It is much easier to graph a chart based on indexed values than one based on actual market values.”[2]

 What does a change in a share market index mean?

“Changes in the index level reflect changes in the total market capitalisation of the index that are caused by price movements in the market.”

A rise in the share index signifies that the total value of companies in the index rose. A fall in the share index signifies that the total value of companies in the index fell.

Price changes usually occur when shares go ex-dividend (see our shares going ex-dividend guide for more info). Index maintainers take this into account when calculating the index and will adjust the total market value of the index and the index divisor so that the index figure isn’t affected.

 What can be included in a share market index?

In the case of the S&P/ASX indices a security must be:

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

In order for a stock to be included in an index such as the S&P/ASX 200 the market capitalisation of a company is assessed. The average of 6 previous months end-of-day adjusted market capitalisation figures are used.

 Why are stocks removed from a share market index?

Companies are removed from an index if they no longer meet the criteria listed above. This may occur when a company significantly changes its structure e.g. through a merger or acquisition.

 Who maintains a share market index?

It is often a mix of index analysts and economists from a private company and from the stock exchange the index is based on.

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

 


[1] S&P/ASX 200 Equity Indices Fact Sheet

[2] Standard & Poor’s: S&P/ASX Australian Indices Methodology