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SPECIAL REPORT: SHARE INDICES


Passive investors usually also enjoy the


benefit of lower costs compared with their active counterparts. The demand for these cheaper products has been a major factor in driving the number of indices available. The growth in indices, and investing


based on them, has consequences. For instance, a greater focus on a specific theme, such as environmental, social, and governance (ESG), may bring more concentration risk. And the universal requirement for indices and the passive products following them to rebalance creates arbitrage opportunities for active managers. With single indexing companies


calculating hundreds of thousands of indices daily, the proliferation of indices has taken significant leaps and bounds since the humble beginnings of such a structure hundreds of years ago.


NOW AND THEN London’s first stock exchange was opened in 1570, eventually leading to Jonathan’s Coffee House in 1698 publishing a list of currency, stock, and commodity prices. However, the oldest stock market index that most closely represents the one that many investment professionals use today is based in the US – the Dow Jones Industrial Average (DJIA), launched in 1896. At launch it comprised 12 stocks of


industrial companies, showing simple averages of the stock prices. The intention was (and still is) to provide investors and traders with an indication of how the aggregate value of the companies in the index change over time. The index now comprises 30 stocks, and it was only in 2018 when the last of the index’s founding stocks, General Electric, was removed in favour of Walgreens Boots Alliance, after being in the DJIA continuously for more than 120 years.


CISI.ORG/REVIEW


The change in composition of the


DJIA more greatly reflects the development of the US economy rather than an alteration to how the index is constructed, with a notable change being Apple replacing AT&T in 2015, a sign that mobile telephony had become dominant over its fixed-line sibling. But the number of indices has grown.


Investors are now able to take far more granular stances rather than simply gaining exposure to a nation’s economy, as expressed by an index such as Germany’s DAX.


// DIFFERENT INDEX PROVIDERS USE DIFFERENT RULES TO CONSTRUCT THEIR INDICES //


The vast range of index products


available facilitates a focus on, among other things, value or growth companies, lower-volatility stocks, or firms paying higher dividends. Other options include an equal-weighted index to avoid concentrating risk into a few large stocks.


INDEX CONSTRUCTION Different index providers use different rules to construct their indices. Some indices, such as the FTSE 100, are weighted by market capitalisation. Others have equal weighting of the companies in their index. Others weight their indices by share price, such as the DJIA. In an equal-weighted index, each


constituent represents the same amount of the index, regardless of its size, while in the price-weighted approach, the share price dictates the weight of a company within an index, regardless of its size. This means a smaller company could command a bigger weighting in such an index based on its share price. However, price-weighted indices could be viewed


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IMAGE: ISTOCK


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