Below is a weekly update from our Chief Investment Officer, Dr. Scott Lummer. He co-hosts an audio segment entitled “Market Matters.” In this week's show, Scott discusses indexes. He explains why of three widely used indexes, the S&P 500 is the best indicator of broad stock market performance. He explains why different funds use different indexes as a benchmark for their performance, and why there are a plethora of stock market indexes. He cautions how analysts can use index data to mislead investors. Each week he covers a different piece of investment news focusing on recent events in the capital markets, and relates them to Savant Investment Group’s perspective on investing.
Daphne: Welcome to Market Matters, a weekly discussion about investing in today’s capital markets. I’m Daphne Feng and, as always, I’m joined by the Chief Investment Officer of Savant Investment Group, Dr. Scott Lummer. Scott, at the beginning of almost every financial news report, the anchor tells us how a stock market index performed. What specifically is an index?
Scott: An index is simply an average of a group of stocks representative of a market or a sector of stocks.
Daphne: I seem to hear three indexes discussed more than any other – the Dow Jones, the S&P 500, and the NASDAQ. What’s the difference between them?
Scott:The Dow is an average of 30 large companies that is representative of the broad stock market in terms of industry diversification. The S&P 500 is a broader index of 500 stocks. The NASDAQ is an index of over 3,000 companies that are listed on the NASDAQ exchange. Because technology oriented companies frequently list on the NASDAQ, the index is more representative of tech stocks.
Daphne: So they’re different, but they all seem to move in the same direction. Why is that?
Scott: The broad market tends to move in the same direction. So any average of a large number of stocks will tend to move in the same direction. While there are days in which one index will increase in value and another will decline, those differences will be small.
Daphne: Which one is better?
Scott: Overall the S&P 500 is the best indicator of broad market performance. The Dow is kind of old school with respect to its limited size, the way it weights the stocks, and it’s inclusion of newer companies. Microsoft and Intel didn’t become part of the Dow until 1999, and Apple, currently the second largest U.S. company, is still not included.
Daphne: So are those the only three indexes measuring the stock market?
Scott: No. There are literally hundreds of indexes measuring various sectors of the market based on industry; company size; style of investing, such as value or growth; and other characteristics, such as high dividends.
Daphne: Why so many indexes?
Scott: Indexes are commonly used to gauge a mutual fund’s performance. So if a mutual fund is typically investing broadly in large U.S. companies, the S&P 500 is a good benchmark. However, if a fund is restricting itself to a more specific universe of stocks, such as small company value oriented stocks, it is more appropriate to use a benchmark reflective of that universe.
Daphne: What about foreign stocks?
Scott: There are broad indexes of global stocks, such as the MSCI all world index or emerging market index, and specific regional, country, size based, style based, and industry based, indexes. At times, it seems that there are more indexes than there are individual stocks.
Daphne: I don’t hear as much about bond indexes. But I know they exist.
Scott: Bond indexes are not as newsworthy because bonds are less volatile than stocks. But they are frequently used to benchmark fund performance. The most common bond index is the Barclay’s Aggregate, which in composed of Treasury, government agency bonds, investment grade corporate bonds, mortgage backed bonds, and some foreign bonds. Other bonds, such as non-investment grade corporates, municipals, TIPS, and most foreign bonds are excluded. But there are specific bond indexes that can be used to measure individual sectors
Daphne: What’s the common misunderstanding of indexes?
Scott: Most basic stock indexes miss an important component of long-term return – dividends. Some analysts use those indexes to either unintentionally or intentionally mislead their readers. I recently read a column in which the author claimed that an investor who put money in the stock market at the end of 1999, at the height of the dot com boom, would have lost money over the next 14 ½ years adjusted for inflation. They cited the S&P 500 index as their proof. However, they ignored dividends in their calculation. If you include dividends an investor would have received, the aggregate return would have been almost 30% even after inflation. While not stellar, it is far from the picture the author tried to paint. I suspect the author knows better, but was doing what many analysts do – distort the data to make their point.
Daphne: And that’s Market Matters. Thank you Scott and thanks to all of you for listening. Please join us next week when Scott and I will talk about bubbles.