Today’s post is a guest post written by my husband George at the beginning of the pandemic. It is a detailed and in-depth post explaining what a stock market index is and what they do. Although the market has fluctuated since then, the principles are solid. The post below is a great one if you are just starting or trying to get your head around what market indexes actually are.

Happy reading!

It’s 2020 and as you know, the stock market tanked earlier this year. In March you would have seen alarming news headlines: “NZX50 slumps“, “NZ share market falls“, and “NZ stocks in bear territory as market plunges“. But by the time we got to December, the news headlines were now announcing: “NZX 50 hits record“, “NZX50 rises to new record“, and “NZX Top 50 surges past 13,000 mark for first time“. These articles often open with a sentence such as: “The S&P/NZX 50 Index rose 73.85 points, or 0.7 percent, to a record 9,982.24.” or “The S&P/NZX 50 Index fell 217.7 points, or 2 percent, to 10,924.88.” As investors, how should we interpret these headlines, and what is this index number? How relevant or useful is this index number to an investing strategy? Let’s dive in!

What are stock indexes?

This index number is a value of the S&P/NZX 50 Index and as of today (21 Dec 2020) is currently 12,607.74. A market index is a collection of shares grouped according to a certain method. The weighting of each share and their share price are averaged out to calculate the index number. Think of indices (plural of index) as tools that represent and measure either a thin or thick slice of a share market. There are thousands of different indices calculated with their own methodologies and values. The S&P/NZX 50 Index is considered the benchmark or most important index of the New Zealand share market. This is the index you will see most widely reported and referenced in New Zealand news media. World-famous benchmark indices include: The Dow Jones Industrial AverageThe S&P 500 Index, and The Nasdaq Composite Index.

Indices are calculated, maintained, and published by index providers. The index provider of the S&P/NZX 50 Index is S&P Dow Jones Indices which is a division of S&P Global. If you visit the official website for the S&P/NZX 50 Index you will not find any options to buy or invest in the index. This is because you can’t buy or invest in an index itself, they are not funds or shares. You can invest in funds and ETFs that copy and track the makeup of an index and attempts to reflect their performance. These investment options are available through other investment providers. S&P Dow Jones Indices only maintain and publish their indices.

Why would you want to group a bunch of shares together anyway? What does measuring the performance of an index mean? As of today (21 Dec 2020), there are currently 185 shares listed on the New Zealand Stock Exchange (NZSX). These 185 shares listed on the NZX Main Board represent the larger New Zealand share market. On any given trading day each one of those 185 shares could rise, drop, or stay at the same price. If you were to write a news headline describing what happened in the share market today, how could you write it? You could try describing what happened to the price of each company in the share market: “AIA declines -0.19%, AIR declines -1.67%, AKL no change 0.0% …”. With 185 shares to go through, you would have to write a very long headline.

Instead of listing the price change for each share, you could try tallying up the information. Such a headline could read: “NZ Share Market: 64 stocks increase in value, 83 stocks decline in value, and 38 stocks have no change in value!” But what are you comparing the increase and decrease in values to? Have shares increased or decreased in value by a lot or barely at all? Let’s compare this headline with a hypothetical headline from two years prior. “NZ Share Market: 99 stocks increase in value, 66 stocks decline in value, and 20 stocks have no change in value!”. We can see that today fewer shares increased in value than two years ago (64 vs 99). We can also see that today more shares declined in value than two years ago (83 vs 66). Are share prices at record highs today or have they dropped after a sharp share market crash? Without some kind of base value to compare the two periods of time to it’s difficult to tell.

Not a new idea

Trying to break down and describe what was happening in a share market is a complex problem. A simple and straightforward solution was created a long time ago. In 1884, Charles Dow created his first market index, The Dow Jones Railroad Average Index. The index was published as part of the “Customer’s Afternoon Letter”. This was a daily printed summary of business news bulletins and closing stock prices. Later this publication would become The Wall Street Journal. Dow created his index by selecting 11 transportation company stocks. These consisted of 9 railroad companies and 2 non-railroad companies and explains the index name. Once Dow had chosen the companies he calculated an average value for the new index. He did this by adding the closing prices for each share in the index together. Next Dow divided this number by 11, the number of companies in the index. This index is the oldest still in use today is now known as the Dow Jones Transportation Average (DJTA).

In 1896, Dow created another index, the Dow Jones Industrial Average (DJIA). This is Dow’s most famous index and is simply referred to today as “The Dow”. Instead of focusing on transportation companies as he had with his first index Dow selected a new method. Dow chose the 12 largest industrial companies in the share market to make up this new index. These were cotton, gas, sugar, tobacco, and oil companies. Dow again calculated an average value for the index using the same method as before. By adding the closing share prices together every day and dividing by the number of shares in the index, 12. The Dow began with a calculated value of 40.94 and as of today has a value of 30,216.45. If enough of the 12 company share prices increased from the previous day, the index value would also rise (e.g. 40.94 to 45.95). If enough of the 12 company share prices decreased from the previous day, the index value would drop (e.g. 40.94 to 38.94).

This was a brilliant idea by Charles Dow. He had created a clear and effective way of summing up what was happening in the share market. This could be easily summed up in only a few words: “The Dow Jones Industrial Average Index rose 5.01 points, or 12.24 percent to 45.95”. Or if share prices declined: “The Dow Jones Industrial Average Index fell 2.00 points, or 4.89 percent to 38.94”. By setting a base value, you could compare how the index value changes over time. As long as the index methodology remained consistent, it could be tracked day to day, week to week, and year to year. Investors follow these changes to see short and long term trends in the overall share market.

Let’s create an index fund

Fast forward to today, there are thousands of indices you could track and follow. If we take another look at the NZX Main Board we can create one ourselves. Remember that there are currently 185 individual shares listed as of today. We are going to create an index for all the companies in the share market that begin with the letter “R”. This index includes a total of 5 companies based on our criteria and let’s call it the DB&B/NZX R Index. The shares for the companies included in the index are: Radius Residential Care Limited (RAD)Rakon (RAK)Restaurant Brands New Zealand Limited (RBD)Rua Bioscience Limited (RUA), and Ryman Healthcare Limited (RYM).

Now that we have selected the criteria for inclusion in our index, let’s calculate an index value. The closing share price for each company on (21 Dec 2020) was: RAD ($1.130)RAK ($0.540)RBD ($11.860)RUA ($0.610), and RYM ($14.700). Let’s use Charles Dow’s original method to calculate the value. We add each individual share price together (1.130 + 0.540 + 11.860 + 0.610 + 14.700 = 28.840). Then we divide this combined value by the number of companies in the index (28.840 / 5 = 5.768). That is, the initial value of the newly created DB&B/NZX R Index as of (21 Dec 2020) is 5.768.

The following day (22 Dec 2020) we recalculate the index again. Investors buy and sell each of the individual shares making up our index and the price for each changes. Once trading has finished for the day, we take the new closing price for each share in our index as of (22 Dec 2020). These are: RAD ($1.090)RAK (0.550)RBD (11.850)RUA (0.580), and RYM ($15.150). Again we add each individual share price together (1.090 + 0.550 + 11.850 + 0.580 + 15.150 = 29.220). We also again divide this value by the number of companies in the index (29.220 / 5 = 5.844). Now we can say that the value of the DB&B/NZX R Index as of (22 Dec 2020) is 5.844. If we were writing a news headline we could state this as: “The DB&B/NZX R Index rose 0.08 points, or 1.32 percent to 5.84”.

Are index funds useful?

The question now after we have created, updated, and tracked our index is how useful would it be to investors? For a start, this index is very narrow as it includes only five companies out of the total 185 available. As the criteria were all companies that begin with the letter “R”, the selected companies don’t have a lot in common. There are two aged care provider companies, a food retail management company, a medicinal cannabis company, and a technology company. The 5 companies clearly do not all belong in the same industry. Our DB&B/NZX R Index is basically a small and seemingly random slice of the total share market. This index would not be of much use for any investor in helping them understand what was going on in the share market.

How did Charles Dow pick the initial 12 stocks for the Dow Jones Industrial Average Index? He selected the largest, most consequential industrial companies in the share market. In modern times there is a more common way index providers choose and rank companies to include. Most index providers rank companies according to Market Capitalisation (Market Cap). This is calculated by multiplying the number of shares of a company by the current share price. The market cap value becomes a real-time estimate of the company’s value. This is because it reflects what investors would be willing to pay for the total value of a company’s shares. The market cap value is also useful to investors in another way. It allows you to compare the relative size of two companies against each other.

To illustrate, let’s calculate the market cap for two of the companies in our DB&B/NZX R Index. As of (22 Dec 2020) Ryman Healthcare Limited (RYM) has a closing price of $15.150 per share. (RYM) also has 500,000,000 outstanding shares or securities issued. We multiply the share price by the number of shares (15.150 * 500,000,000 = 7,575,000,000). This gives us a market cap value for (RYM) of around 7.5 billion. Let’s repeat this calculation with another company, Rua Bioscience Limited (RUA)(RUA) has a closing price as of 22nd December 2020 of $0.580 per share. (RUA) also has 140,262,591 outstanding shares or securities issued. Again we multiply the share price by the number of shares (0.580 * 140,262,591 = 81,353,303). This gives us a market cap value for (RUA) of just over 81 million. We can compare these two companies and see that (RYM) has a market cap around 93 times larger than that of (RUA).

Our DB&B/NZX R Index is very narrow in that it only includes companies on the share market that start with the letter “R”. The index would be much more useful if it includes the largest companies by market cap in the share market. This is because it would reflect a wider slice of the share market as a whole. It would be more reflective of what’s happening in the wider market and not just with 5 companies out of 185. Famous other benchmark indices tend to feature a wider selection of companies. The Dow Jones Industrial Average Index now includes 30 companies, the S&P 500 Index includes 500 companies and the Nasdaq Composite Index includes over 2,500 companies.

The Kiwi benchmark

The first market index was introduced in New Zealand in 1957. It was established by the stockbroking firm Daysh Renouf which was run by Sir Frank Renouf. This index included 40 of the largest companies by market cap listed on the stock exchange. The index started with an initial value of 100. The index value was then calculated monthly at first, weekly by 1962, and daily by 1966. In 1960 Sir Frank established New Zealand’s first merchant bank. The bank was named New Zealand United Corporation (NZUC) and the index was given the name of the NZUC Index. In 1983 Barclays Bank acquired a shareholding in New Zealand United Corporation. The index was then renamed again the Barclays Index. By 1991 Barclays Bank had transferred control of the index to the New Zealand Stock Exchange (NZSE). Shortly afterward the index was renamed again, this time as the NZSE 40 Index.

One of the benefits of using indices is that short and long term trends of the index can be tracked over time. Some indices such as the Dow Jones Industrial Average can be tracked over decades. But this relies on index methodologies also remaining consistent to make accurate comparisons. These index methodologies are not set in stone however. Index providers can and do change the rules for how they calculate their indices. On March 3, 2003, the NZSE (now renamed NZX), replaced New Zealand’s headline Index. The NZSE 40 Index (now named the NZX 40 Index) was replaced with the new NZX 50 Index. This index added an extra 10 companies to the number of companies included in the headline index. An initial base value of 1880.85 was set for the first day of trading. This value was the same value the NZX 40 Index had closed on the previous trading day. The NZX made two other significant changes in how the headline index was calculated. These included first turning the index from a Capital Index into a Gross Index. The second major change was in the use of Free-float market capitalisation.

Viewing returns

Let’s look at another one of those headlines we looked at earlier: “NZX50 rises to new record“. The article states that earlier that day (30 Nov 2020) the S&P/NZX 50 Index reached a record high value of 12,768.52. What happens if we visit the official website for the S&P/NZX 50 Index and try to find the value for that date? Looking at the index graph we can see that the value for (30 Nov 2020) is 5,361.13. Why don’t these two values match up? The answer is in how share returns are incorporated and reflected in a market index. For indices, there are three ways returns can be calculated and incorporated. These are: Capital, Gross, and Gross with Imputation Return indices. Each of these indices calculates returns slightly differently from each other. This results in a different index value for each.

Capital Indices are also called Price Return Indices. These represent movements in the prices of the companies which make up the index only. If a company in the index were to pay a dividend, this will not affect the calculated value of the index. New Zealand’s previous headline index, the NZX 40 Index was a capital index. Other famous headline capital indices include the Dow Jones Industrial Average Index, the S&P500 Index, and the Nasdaq Composite Index. Gross Indices are also called Total Return Indices. Gross Indices also reflect the movements in the prices of the companies of the index. These differ from Capital indices in that they include dividend and distribution returns. The dividend returns are calculated assuming all distributions are reinvested across the index. How much of the dividend goes to each company is calculated according to the shares index weight.

The third type of index is Gross with Imputation Return Indices. These indices also reflect the movements in the prices of the companies of the index. They also include dividends and distributions as the Gross indices do. These differ in that they include the reinvestment of imputation or franking credits. These credits are also calculated assuming all credits are reinvested across the index. Capital Indices do not include dividends, distributions, or tax credits, unlike Gross Indices. Because of this, Gross Indices will always have a higher calculated index value.

Let’s look again at the official website for the S&P/NZX 50 Index. On (30 Nov 2020), the Capital value was 5,361.13, the Gross value was 12,768.52 and the Gross with Imputation return was 15,617.69. You can see that the Gross value of 12,768.52, is the value that matches our previous news headline. The Gross value of the S&P/NZX 50 Index is the index value most widely reported in New Zealand media. Why did the NZX decide to shift from a Capital headline index to a Gross headline index? They believed that it was essential to consider the total return of the share market. New Zealand companies had been paying comparatively high dividends compared to overseas companies. Using a Capital headline would understate the returns achieved by the share market. A Gross headline index would also better reflect an investor’s actual returns.

Tradable shares

Using Free-float Market Capitalisation was the second change made to the headline index. The NZX 40 Index had reflected the price performance of the largest companies in New Zealand. These companies were ranked the largest in terms of market capitalisation. This methodology gives a good estimate and ranking of a company’s size with other companies. What this method does not take into account though is the availability of company shares. The free-floating market cap of a company represents the portion of a company’s total shares that are freely tradable. Shares that are held by company insiders or controlling investors are excluded. The free-floating market cap value is calculated minus these shares. This will generally result in a smaller market cap value calculated for each company.

To illustrate why the availability of shares can be an issue, let’s look at one company currently in the S&P/NZX 50 Index. As of (22 Dec 2020) Air New Zealand (AIR) had a closing price of $1.715 per share. (AIR) also has 1,122,810,044 outstanding shares or securities issued. We multiply the share price by the number of shares (1.715 * 1,122,810,044 = 1,925,619,225). This gives us a market cap value for (AIR) of around 1.9 billion. The New Zealand Government currently owns 582,854,593 or 52% of all (AIR) shares. The Government has held these shares since it bailed out the airline in 2001. The Government rarely sells any of their holdings and so are classified as a long term investor. In this case, 52% of all (AIR) shares are effectively not available to the public to buy. How can an investor achieve returns reflected in an index if they can’t buy shares that make up the index? The larger the weighting of a company in an index the larger the issue becomes.

This issue was even more pronounced back in 2003. During this time the Government owned 82% of all (AIR) shares which left at most, 18% available to the public to buy. Remember that this simple example does not include company insiders or controlling investors. The actual amount of shares available to the public could have been even less than 18%. A free-floating market cap is used to reflect the actual availability of shares of a company in an index. The difference between the classic market cap is that it excludes unavailable shares. Let’s work out a rough free-float market cap for Air New Zealand (AIR). The Government holds 52% of all (AIR) shares which comes to 582,854,593 shares. Now we remove these shares from the total amount of shares (1,122,810,044 – 582,854,593 = 539,989,634). We use the market cap calculation to multiply the share price by the number of shares available (1.715 * 539,989,634 = 926,082,222). This gives us a free-floating market cap value for (AIR) of around 926 million (a billion less than the original market cap!). (AIR) would rank much lower in an index ranking now and it better reflects the availability of the shares.

Things to consider

Now we know what a market index is, how it is constructed, and some of the methodologies behind them. We know which indices are useful to follow such as the S&P/NZX 50 Index. We know that broad indices can tell us generally what is going on in the overall share market. How else can market indices be useful to investors? One benefit is that you can use indices as a baseline to compare with your own investment portfolio. In this way, you can think of an indices performance as an average value. If over the last year the S&P/NZX 50 Index has risen over 15%, how have your investments compared during the same time? If your investment portfolio has risen 12%, you have underperformed the market average. If your investment portfolio has risen 17%, you have outperformed the market average.

There are a few things to keep in mind when comparing indices and investments. The first is that indices do not take into account transaction costs and fees. Such costs include brokerage and yearly account fees. If you were to buy all the companies in the S&P/NZX 50 Index you would need to pay brokerage fees for each share. This would quickly add up as you would need to purchase 50 different shares. Companies are constantly gaining or dropping in ranking in the index. You would need to be constantly buying and selling shares to match the index’s allocation. This cost would be difficult to include in the index as not all brokers charge the same fees. Another thing that indices don’t take into account is tax. What an investor’s tax status is and what rate of tax they pay is unique to the investor. Indices do not model brokerage, fees, or tax rate and status. Remember this when comparing the performance of an index to your own investments.

Summing it all up

So there you have it! The next time you see a headline about the S&P/NZX 50 Index hitting an all-time high or falling fast, you will know what it means. You will know that this index includes 50 of the largest companies on the New Zealand share market. You will know that those companies are measured and ranked using their free-float market capitalisation. You can use this value to give you a quick impression of the state of the entire New Zealand share market. You can track how the index has performed over time by seeing trends and patterns. You can use the index as a baseline to compare how your own investment portfolio has performed. You know that you can’t invest in an index but you can invest in options that copy and mimic their performance.

Did you learn something new about stock indexes? Let me know in the comments 🙂

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