What is an Index?
An index is a statistical sample of a market or sector. The most commonly known index is the S&P500, which serves as an overall US Equities market benchmark. When investors refer to the market doing well or poorly they are generally basing this on the performance of the three main US Indexes: the above-mentioned S&P500, the NASDAQ Composite, and the Dow Jones Industrial Average. All three are unique in the way they weigh each stock in the index, as well as which stocks are included.
Investors can use these indexes to gain a better understanding of how different markets are performing. Large indexes are generally market indexes and represent entire economies such as the DAX (German stock index), comprised of the 30 major German companies trading on the Frankfurt Stock Exchange. However, they can also represent smaller niches such as an airline index, biotech index, or microprocessors index. Indexes are also used to measure other investments such as commodities.
Above is an example of the NASDAQ Biotechnology index.
Investors use indexes as a benchmark to measure performance. The metric Alpha represents the performance above the market, or excess return (loss). TipRanks Ultimate users can use the benchmark filter to measure an expert’s performance against a benchmark, such as a broad-market index or sector index, giving a more realistic indication of actual performance.
For example, an analyst whose recommendations made a 25% return in 2013 might sound very impressive; however, during that year the market rose by a staggering 32.4%. With this in mind, the analyst’s recommendations performance was actually 7.4% less than the overall market. Alternatively, if he were to make the same return in 2014 this would be an impressive achievement, because that year the S&P500 rose just 13.8%, representing an Alpha of 11.2%.
It is common for investors to mistakenly believe that an index holds actual value when indexes are really just mathematical models. In reality, to invest in an index, you would have to purchase the exchange-traded fund (ETF), or an index fund that reflects the components of a specific index. For example, the most popular investment vehicle for having an S&P500 portfolio is SPDR S&P500 (NYSE Arca: SPY), which closely imitates the index. However, due to physical constraints, it is nearly impossible to replicate the index one for one, and thus the returns might deviate slightly from one another (for better or worse).