Ins and Outs of Indexes

First rule of tracking the market: Know thy benchmarks.

The lights are low and the tension is high on the set of Who Wants to Be a Millionaire? as Regis reads you the $1 million question: “The Wilshire 5000, the Russell 2000 and Standard & Poor’s 500 are: a) the latest additions to the NASCAR racing circuit; b) splinter groups of the rock band 10,000 Maniacs; c) three new fad diets; d) gauges that help investors keep track of the U.S. stock market.” ♦ Okay, so maybe this fantasy is a stretch. Even if you did make it to the final round of Millionaire, you would probably get a question like, “Including the thumb, how many fingers did Henry VIII’s second wife Anne Boleyn have on her left hand?” (The answer, history buffs, is six.)

But there are plenty of reasons besides game show glory to familiarize yourself with the stock market benchmarks that are bandied about in the financial press. The most compelling: Comparing the performance of different indexes can provide insights into what’s really going on in the stock market as well as your own portfolio.

Knowing your way around popular indexes is especially important today because returns can vary widely from one sector of the market to another. Over the past year, for example, many tech stocks have stampeded to mind-boggling gains, leaving the rest of the market to eat their dust. Which is why the tech-laden Nasdaq composite index towers over the other four widely followed benchmarks in the chart above.

This month I’ll give you the lowdown on five U.S. market indexes. Yes, it would be more convenient if just one index could tell you everything you need to know. Unfortunately, investing — like life and TV quiz shows — isn’t always as simple as we’d like. So I suggest you keep tabs on several of these benchmarks, which, come to think of it, really isn’t too much to ask, since stats on all of them are readily available in print and on the websites listed on page 60.

The Dow Jones industrial average. The Dow contains only 30 large-company stocks that represent less than 30% of the value of the U.S. equity market. But for most individual investors, the Dow is the market. That’s largely because it’s had a long time to etch itself into our psyches. Wall Street Journal co-founder Charles Dow—a tall, bearded fellow who bears an uncanny resemblance to the equally hirsute guys pictured on boxes of Smith Brothers cough drops—started the index back in 1896 with just 12 stocks to track the then emerging industrial sector of the American economy.

Today two people decide which 30 stocks make up this influential index: Wall Street Journal managing editor Paul Steiger and John Prestbo, index editor at Dow Jones & Co. (owner of the Journal), who’s better known to his colleagues as “the keeper of the Dow.” Their mission, says Dow high priest Prestbo, “is to create an index of 30 stocks that advises people whether the market – and by extension the economy is moving up, down or sideways.” They give themselves wide latitude on accomplishing that task. Although Dow stocks tend to represent a cross-section of industries — including not-exactly-industrial firms like Citigroup and McDonald’s — Steiger and Prestbo hew to no specific guidelines on market cap, sector weightings or any other standard measures. “The Dow is a subjective index,” says Prestbo.

Critics would add that it’s also flawed and irrelevant. Take the way the Dow is calculated. Nearly all major indexes, including the ones mentioned below, are market-cap weighted — that is, the bigger the stock’s market value, the more its performance counts when calculating the return for the index. In the Dow, however, each stock’s weight is based on its price. That can lead to some pretty bizarre results. Microsoft had a recent market value of $596 billion, or nine times that of American Express. But because AmEx has a higher stock price — $155.56 recently vs. $112.75 for Microsoft — a 10% move in the price of AmEx would boost the Dow roughly 76 points while the same increase in Mr. Softee’s share price would push up the index only 55 points. I call that the tail wagging the Dow. Price weighting gave Charles Dow a quick way to calculate his index before the advent of Pentium III processors. But even Prestbo admits that he wouldn’t use this method if he were launching the Dow today.

Dow bashers also charge that the index is light on New Era stocks, specifically Internet shares. Prestbo bristles at this criticism. “Wall Street likes to have its latest fads represented in the popular indexes because that helps them tell their story to people who might give them money to invest,” he says. “But we have to take both the economy and the market into account, which frequently makes us slower to move than Wall Street would like.” Prestbo feels that the round of changes made in October — in which Microsoft, Intel, SBC Communications and Home Depot replaced Sears, Goodyear, Chevron and Union Carbide — make the Dow a good representation of the markets and the economy as we enter the third millennium.

Call me sentimental, but despite its shortcomings I still think it makes sense to follow the Dow. Not because it’s a good yardstick for evaluating the market overall. I don’t think 30 stocks cover enough ground for that. But the compelling reason for keeping an eye on the Dow, quite simply, is because so many people do so. “The fact that it’s so widely watched means it affects market psychology and investor behavior,” says Tim Hayes, global equity strategist at Ned Davis Research.

Standard & Poor’s 500 index. The S&P 500 didn’t make its debut until 1957, the same year as Leave It to Beaver. But with its 500 large-cap stocks that account for about 80% of the total value of the U.S. stock market, it’s become the benchmark most money managers think of as a proxy for the market—and the one fund companies most frequently turn to as a model for creating an index fund.

But even though the S&P 500 pretty closely tracks the market’s weightings in 25 major industry groups, there’s still a whole lot of subjective judgment going on behind the curtain when it comes to picking the index’s stocks. Basically, a nine-member S&P index committee headed by S&P chief economist Charles Blitzer chooses stocks that represent what Blitzer refers to as “leading companies in leading industries.” That doesn’t mean the biggest stocks. Brick-and-mortar retailer Sears, with a recent market value of $12 billion, is in the index; cyber-retailer Amazon.com, with a market cap of $35 billion, isn’t. “My personal sense is that a company should have some earnings,” says Blitzer, “but that’s not unanimous on the committee. We’re going to continue to look at [this issue].” And although the S&P 500 is supposed to represent the U.S. market, it still contains a handful of foreign companies, including Royal Dutch Shell and the Seagram Co. — but not DaimlerChrysler, even though Chrysler was in before the companies merged.

Despite such little quirks, the S&P 500 is a good proxy for big-cap stocks, emphasis on the “big.” The index’s 40 largest stocks alone represent more than half the S&P 500’s total market value of $11.7 trillion. So behemoths like Microsoft, General Electric, Intel and Wal-Mart account for a disproportionate share of the S&P 500’s returns. Even if you own all 500 stocks, your returns could vary substantially from those reported for the S&P 500, if your holdings are not in the same proportion as the index. In 1998, for example, the S&P 500 index gained 26.7%, excluding dividends. But if you had invested in equal amounts of all 500 stocks at the beginning of the year, says Leuthold Group analyst Jim Floyd, you would have enjoyed only a 10.7% gain.

Does that mean the S&P 500 is misleading? Not if you’re tracking the growth of wealth in the U.S. stock market. The S&P 500’s market-cap weighting accurately reflects the flow of investor dollars into the market. The biggest stocks became big because investors plowed money into them and drove up their share prices. But the outsize weighting of the biggest stocks does mean that the index return won’t necessarily tell you much about how the bulk of the stocks in the index performed. You can get a more detailed look at the S&P 500’s performance, including returns by various industry groups, by going to the website of Deutsche Bank chief economist Ed Yardeni, which is listed in the box above.

Nasdaq composite. Technically speaking, the Nasdaq composite isn’t an index, since it wasn’t designed to represent any particular slice of the market. Rather, Nasdaq—which draws its name from the National Association of Securities Dealers’ Automated Quotation system, launched in 1971—is just a market cap weighting of all the stocks listed on the Nasdaq market, roughly 4,800 issues. I’ve included it in our little roundup, however, because the Nasdaq’s recent rampage — up 71.1% for the 12 months to Dec. 1 — has garnered this index as much attention as the Dow.

But when you hear about Nasdaq — and you can hardly avoid it these days — remember: Its breathtaking returns are actually being generated by its humongous weighting in technology—roughly 70% of its total market value vs. 28% or so for the S&P 500 — and just a handful of large tech stocks at that. (See the chart on page 58.) As a result, the Nasdaq can and often does move in the opposite direction of the S&P 500 and the Dow any given day.

There are definitely purer technology indexes out there. But for a quick daily take on how tech stocks — especially large tech stocks — are doing, Nasdaq is certainly a decent benchmark.

Russell 2000. If you want to see how the small stocks or small-cap funds in your portfolio are faring compared with their runty brethren, you should check out the Russell 2000. In the 15 years since this index was created by investment consulting firm Frank Russell Co. of Tacoma, Wash. to help institutional investors track the small-cap market, the Russell 2000 has pretty much become the small-stock standard.

Depending on your point of view, the methodology to create this index could be described as quantitatively rigorous or borderline compulsive. Each year at the end of May, the Frank Russell “index production team” ranks the top 3,000 U.S. companies by their market value (after excluding, among other things, limited partnerships, closed-end mutual funds and stocks with prices below $1). The 1,000 stocks with the highest market caps are dubbed the Russell 1000, while the next 2,000 become…tada!… the Russell 2000.

Out of this largely computerized process comes a pretty good benchmark of what most investors would consider the small-cap market. When the index’s roster was last reset in May, the market values of the companies ranged from $178.2 million to $1.3 billion with a median of $428 million. To get a better idea of what size companies we’re talking here, consider this: The market value of all 2,000 stocks in the Russell 2000 is less than the combined market cap of Microsoft and General Electric. Bottom line: By comparing the returns of the Russell 2000 to those of, say, the S&P 500, you can get a good idea of how the Davids of the stock market are faring vs. the Goliaths.

Wilshire 5000. I’ve saved for last the index that covers the whole enchilada, or the entire U.S. stock market. Despite the nice round number in its name, this mother-of-all-U.S.-indexes actually contained 7,091 stocks recently. “When we started the index, it had about 5,000 stocks in it,” says Michael Sanchez, an analyst with Wilshire Associates in Santa Monica, Calif. “But as time went on, it just grew.” Whatever the actual number — it changes because of IPOs, mergers and the like — the Wilshire 5000 pretty much represents all publicly traded stocks in the U.S. of A.

As broad as the Wilshire 5000 is, however, it’s still dominated by large caps. The biggest 500 stocks represent 82% of the index’s total value of $14.6 trillion, and the next 2,500 bring that percentage to 97%. So the remaining 4,000-plus issues account for a measly 3% of the index’s market value. It’s not surprising, therefore, that the Wilshire 5000’s performance tends to track that of the S&P 500 pretty closely, with the Wilshire slightly outperforming the S&P 500 in years when small stocks shine and lagging somewhat when the big bruisers go on a tear.

Still, the Wilshire 5000 is the best gauge we have for measuring the ebb and flow of stock market wealth in the U.S. So if you want to compare the growth of your portfolio against that of all other investors in U.S. stocks combined, the Wilshire 5000 is your bogey. And that, Regis, is my final answer.

Senior editor Walter Updegrave is the author of Investing for the Financially Challenged (Warner Books). You can reach him at investing101@moneymail.com.