Market Data, Indices & Benchmarks

Definition

An equity index is a statistical measure that tracks the performance of a basket of stocks representing a specific market, sector, or investment theme. They are used as benchmarks, underlyings for ETFs and derivatives, and indicators of market sentiment.

Major Global Indices (by Region)

A. Price-Weighted Index

Each stock’s weight is proportional to its share price. Higher-priced stocks have more influence, regardless of their market cap. The Dow Jones (DJIA) is a famous example.

Example: If Stock A is $100 and Stock B is $25, Stock A has 4x the weight of Stock B, even if it's a smaller company.

B. Market Capitalization-Weighted Index

Each stock’s weight is its market cap divided by the total market cap of all constituents. This reflects a company's economic size. The S&P 500 is a primary example.

Example: In the S&P 500, Apple and Microsoft make up a significant portion of the index's weight due to their massive market caps.

C. Float-Adjusted Market Cap Weighting

This is the modern standard, used by S&P, MSCI, and FTSE. It is similar to market-cap weighting but excludes restricted/non-tradable shares (e.g., insider or government holdings) to reflect the actual investable portion of the company.

D. Equal-Weighted Index

Every stock in the index is given the same weight (e.g., 1/500th in an equal-weighted S&P 500). This requires regular rebalancing and gives smaller companies more influence than in a market-cap index.

Definition

Rebalancing is the periodic process of updating an index’s constituents and weights to ensure it continues to accurately represent its intended market segment.

Mechanism

1. Data Review: The index provider reviews all eligible companies based on criteria like market cap, float, and liquidity.
2. Additions/Deletions: Companies are added or removed based on their ranking.
3. Weight Adjustment: Weights are recalculated based on new market values.
4. Implementation: Portfolio managers and ETFs tracking the index must adjust their holdings accordingly.

Example

When Tesla was added to the S&P 500 in December 2020, it triggered approximately $80 billion of inflows as passive funds tracking the index were forced to buy its shares to stay aligned with the new composition.

Definition

Specialized indices created to represent specific sectors, themes, or strategies. They are often used for benchmarking or as the basis for investment products like ETFs.

Types & Examples

Benchmarking

The process of comparing a portfolio’s performance against a relevant reference index to measure its relative return (alpha).

Example: If a portfolio returns 10% and its benchmark (the S&P 500) returns 8%, the portfolio has generated an alpha of +2%.

Tracking Error

Measures how closely a portfolio or ETF tracks its benchmark. It is the standard deviation of the difference between the portfolio's and the benchmark's returns.

Causes of Tracking Error: Fees, transaction costs, sampling instead of full replication, and cash drag (uninvested cash).

Price Return Index

Reflects only the price appreciation of the constituent stocks and excludes dividends. This is the version most often quoted in daily financial news (e.g., the standard S&P 500 index value).

Total Return Index

Reflects both price changes and the reinvestment of all dividends paid by the constituent stocks. This represents the true, complete return an investor would receive over time.

Formula: Total Return = Price Return + Dividend Yield (Reinvested)

Example

Over a 30-year period, the S&P 500 Price Index might rise ~700%, but the S&P 500 Total Return Index could rise ~1600% due to the powerful effect of compounding reinvested dividends.

Summary Table

Final Interview Tips

Know the difference between price-weighted and market-cap-weighted indices. Understand index rebalancing mechanics and their market impact. Be able to explain tracking error and the critical difference between price return and total return.