Indexes Not Created Equal

Physician's Money Digest, October 2005, Volume 12, Issue 14

There are dozens of marketproxies, all striving tomeasure the movementof stocks (or bonds, commodities,internationalmarkets, etc) over a given period. Doesit really matter which is used? If youare one of the millions of individualswith some of the billions of dollars tiedto any of the indexes, it does matterthat you understand how they are constructedand what they measure.Furthermore, you'll want to assessyour own investments against yardsticksthat reflect your own goals.Whether you are buying a fund basedon an index or using an index as amarket proxy against which to measureyour own stock selections, it's importantto understand what makesthe index tick. The following is a listof different market indexes and howthey operate:

•The Dow Jones IndustrialAverage. While most equate the Dowwith the market, the Dow is just 30stocks—a mere sliver of the more than8000 publicly held US companies. Untilrecently, the Dow was dominated byheavy industrial stocks. In fact, the Dowwas created in the early 1900s as aneconomic proxy of the health of America'skey manufacturing companies, notto represent the stock market. Furthermore,the Dow is price weighted—calculatedby adding the dollar values ofeach component and then dividing byan adjustment factor to account forsplits and dividends. The current divisoris less than one, meaning its impact onthe Dow's daily point swings is magnified.A 10% change in the price of 3M,for example, moves the Dow 62 points,while a 10% change in General Electricmoves it 26 points.

•The S&P 500. This popularindex is weighted by each company'smarket value (ie, shares outstandingtimes price), rather than price alone.Today's top five names encompass13.5% of the S&P 500's total capitalization;the top 10% represent morethan half its value. The common beliefthat this index is the 500 companieswith the largest market capitalizationis not true. The S&P 500 is in effectmanaged by a committee that chooseswhich stocks are allowed in whensuch changes as mergers, takeovers,and bankruptcies occur. This committeecan guide industry and sectorweights to reflect the changing shapeand structure of corporate America.

•The Russell Indexes. Attemptingto address the biases inherent in theDow and the S&P, the Frank RussellCompany created the Russell 3000Index. On the last trading day eachMay, the market capitalization of alldomestic public companies is analyzedwith the largest 3000 forming theRussell 3000 Index. This group is thensplit into two capitalization-weightedgroups. The largest groups become theRussell 1000 and the remainder formthe Russell 2000. The arbitrary annualreset date can produce 25% to 30%turnover in these Russell indexes. Forexample, in May 2000, many Internetand high-tech companies moved intothe Russell 1000. A year or two later,the majority fell back into the Russell2000. Unlike the S&P 500, where thecommittee's oversight can affect sectorweightings, the Frank Russell Companydoes not manage index components.

•The Nasdaq. The Nasdaq CompositeIndex is comprised of all issuescurrently listed exclusively on theNasdaq market. Historically, manytechnology companies, such as Microsoft,Oracle, Dell, and Qualcomm,preferred the Nasdaq listing ratherthan the NYSE for a variety of reasons,including its younger and technology-forward perception. Unlikethe NYSE, the Nasdaq market isaccommodating to companies withmultiple classes of stock, so many keymedia companies, many of which stillhave significant founding familyinvolvement and multiple stock classes,also opt for that venue.

•The Dow Jones Wilshire 5000Total Market Index. Though thename implies measurement of 5000companies, the Wilshire 5000 measuresthe performance of all publiclytraded US companies no matter onwhich exchange their shares are listedor what their market capitalization.First formed in 1974, its intent was toprovide an unbiased interpretation ofthe share price movement of the entiremarket and the average stock.

Given the differences in the compositionand calculation of the indexes, it'snot surprising that performance numbersvary. For example, between theMarch 2000 bull market peak and theOctober 2002 bear market bottom, theNasdaq composite fell 78%, the S&P500 declined 51%, the Wilshire 5000dropped 50%, and the Dow fell 36%.Performance disparities grow wideramong the more narrowly focusedindexes, such as the Nasdaq 100, theDow Transportation or Utility Averages,or the S&P Financial Index.

Carol Clark is a principal of Lowry Hill, a private

wealth management firm providing

multifamily office services and holding more

than $6 billion in assets for 300 client families

across the United States. Lowry Hill's

investment management minimum is $10 million. Its

offices are in Minneapolis, Minn; Naples, Fla; and

Scottsdale, Ariz. Ms. Clark welcomes questions or comments