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A beginners guide to understanding market index

Market index in finance measures the performance of a portfolio of companies or assets in its holdings. They are also known as a benchmark index. Depending on the type of the financial asset a market index tracks, they can be classified into categories.

The major market indexes are managed by companies such as Dow Jones, Standard&Poors’, MSCI, FTSE Russell and many more. Investing in a market index allows investors to choose between any financial sector and asset class.

The world of market index started with the Dow Jones Transportation index in July 1884.

It was created by the famous Charles Dow. Since then, the financial markets have seen an rise in market indexes.

Different types of market index

Investors can gain access to any market index for trading. Below are the most popular market indexes depending on the type of asset you want to track.

Equity Indices

Equity indices track the performance of selected stocks in a stock exchange. The benchmark equity market index is a proxy for the economy’s equity markets. It is a measure of how bullish or bearish investors are in the equity sector.

The equity market index is categorized based on stocks with largest market capitalization.

The most famous is the Dow Jones Industrial Average or DJIA30 and the S&P500 index in the United States.

Depending on the composition and structure, the number of holdings in the equity indices can vary. For example, the DJIA tracks the 30 largest publicly traded companies. On the other hand, the S&P500 tracks 500 large cap companies in the U.S.

Commodity Indices

Commodity market index tracks the performance of a select group of commodities or companies related to the commodity markets.

These can be further classified into the type of commodities and includes the portfolio of company holdings under it.

For example, the Philadelphia Gold & Silver index (PHLX) tracks the top thirty gold and silver mining companies in its holdings.

Depending on the type of commodity market index you choose, investors can gauge the performance of the commodity sector based on the holdings in the index.

Other types of commodity indices include natural gas, energy market index, oil market index and so on. You can gain exposure either on the mining/manufacturing side or track the performance in the holdings of the various commodities in the respective indexes.

Currency index

Currency indices tracks the performance of a currency against a basket of currencies in its holdings. The most popular of all currency indexes is the US Dollar Index or the DXY.

The DXY  tracks the performance of the US dollar against a basket of six currencies.

Market Index: Example of a currency index
Market Index: Example of a currency index

Currency indexes helps investors understand the overall strength of the currency that is tracked. These types of indices can be derived based on the underlying futures contracts of the various currencies in the index holdings.

Besides the Dollar Index, other popular currency indices include the Bloomberg British Pound Index, Euro Index and many more.

Fixed Income indices

Fixed income market indices track the performance of the fixed income assets. These assets range from sovereign or corporate bonds, inflation linked notes and other variations.

The popular fixed income indices are the FTSE Russell World Government Bond Index (WGBI) or the FTSE Eurobond Indices.

The Fixed income indices work in the same way as equity indices. The difference is that fixed income indices track the performance in the debt markets.

Why should you choose a market index?

iShares MSCI Emerging Markets ETF Fund Market Index.png
iShares MSCI Emerging Markets ETF Fund Market Index.png

In the financial world, investors used indices as a benchmark for comparing their portfolio returns.

When a hedge fund or an investment firm beats the market, it means that their returns outperformed the benchmark index.

Investors can buy stocks of a company directly. But this involves actively managing your positions in the individual stocks. Investing in an index is better because it automatically tracks a basket of stocks. This is known as “Passive investing.”

But there are many funds such as ETF’s and Mutual funds that allow you to do so, indirectly. These funds re-create the index portfolio, comprising of the same companies under the index holdings. Index funds are managed by a portfolio manager.

Trading index CFD’s is another way to invest in indexes in the short term. Index CFD trading comes with the advantage that you can use leveraged funds.

Index CFD is a derivative product which tracks the performance of the underlying index. CFDs are speculative instruments and they are used to hedge positions in the underlying market.

Furthermore, since you are trading Index CFD’s it allows you to go both long and short on the index. This is not possible if you were investing in an index ETF or a mutual fund.

For many, investing in a market index offers a hassle free approach to tracking the market performance for as basket of stocks.

If commodities are of interest, an investor can choose to invest in a commodity index. This allows for easier portfolio management comparing to managing each of the individual stock holdings in a portfolio.

When you are investing in an index, you are merely replicating the performance of the broader market. You cannot beat the market if you are investing in an index.

Benefits of trading indexes

Trading indexes as CFD’s allows you to diversify your trading strategies. Traders tend to focus on just one market such as currencies or precious metals or commodities.

There is no diversification with this approach. Depending on the market, you will see similar trends no matter what instrument you trade.

Below is a summary of the advantages of trading using a market index.

  • Geographical diversity: As there are many regional market indexes, investors have the choice of diversification. For example, you can choose to trade a TSX30 (Toronto Stock index) and the S&P500/ASX index in Australia. This helps you to isolate the risks from one economy to another.
  • 24 hours access to the market: Market index trading allows you to access a 24 hour market. When the European markets close, you have the option to trade in the Asian markets. Likewise, when the US market hours are closed, you can access equity indexes in Singapore or Mumbai.
  • Thematic distribution: By choosing between a currency index or an equity index, investors can choose a thematic strategy. This enables better risk management. For example, a higher US dollar index will not have an impact on an equity index tracking the performance of technology companies.
  • Clear trends: Trends in the market indexes are more observable and sustained. Hence, investors and speculators can use trend trading strategies to pick bottoms within the trend. You can also use medium to short term trend trading strategies

What is the idea behind using a market index?

The idea of indices is to create a benchmark to track the performance of a sector of the economy.

This benchmark allows portfolio managers, economists and financial analysts to gauge the health of the general economy. When the stock market indices outperform fixed income indices, it signifies that an investor is more prone to taking higher risk.

Stock market indices are historically a good proxy for gauging the economic health of a nation.

Even central bank policy makers keep track of the indices when it comes to making key policy decisions such as hiking or cutting interest rates.

Other examples include the currency index. Investors use the performance of a currency index to assess the trends in the currency markets. This also helps policy makers understand whether the exchange rate is too high or too low.

Why are indices important?

Indices or indexes are important because they can tell you how a sector of the financial market is performing. Tracking indexes allows market participants to learn more of any bubbles that may be brewing.

Because there are many different types of indexes, it gives a snapshot of the economy. For example, you could compare the stock market index performance against a fixed income index.

This allows investors a glimpse into how well interest rates is working, as well as point to inflation expectations in an economy.

Depending on what sector indexes you choose, such as the different commodity indices, investors can diversify their portfolios. Diversification enables investors to distribute their risks across the different sectors or themes.

One can also gauge the sentiment in the market as well by tracking indexes. For example, rising commodity indexes can signal a weaker US dollar and hint at rising inflation.