The Major American Equity Indices

DOW, Nasdaq, S&P 500, Russell 2000 and Wilshire 5000

by Ben Best


  4. THE S&P 500 INDEX


By the turn-of-the-millenium about half of the world's stock market capitalization was trading in the United States — up from about 30% a decade earlier. During the same period Japan's share shrank from 40% in 1990 to 11%. In the American market the technology sector had doubled from 10% in 1990 to 20%.

The New York Stock Exchange ("The Big Board") dominated American stock market activity for two centuries, dating from its first informal organization in May 1792. Members of the NYSE are brokers, odd-lot dealers, traders (speculators) and specialists (every listed stock must have a specialist). Trading is governed both by the rules of the NYSE and the rules of the Securities and Exchange Commission (SEC). Most trades on the NYSE are customer-to-customer, while the rest are customer-to-dealer. For large orders, customers can save money by avoiding dealers who profit from the spread between bid-price and ask-price. For small orders & infrequently-traded stocks, dealers (who maintain inventories of stocks) provide liquidity for customers separated in time & place.

Most American common stock trades either on the New York Stock Exchange (NYSE) or The Nasdaq Stock Market. The American Stock Exchange (AMEX) was rapidly diminishing in importance until the emergence of Exchange-Traded Funds (ETFs), index-tracking funds known as Unit Investment Trusts (UITs) that trade like stocks. So-called "Cubes" (QQQs) which tracked the Nasdaq-100 Index were by far the most heavily traded stocks on the AMEX.

Index mutual funds (index funds) and ETFs are both used to invest in an entire index, rather than in individual stocks. Unlike index funds, which are priced when the market closes, ETFs can be bought and sold throughout the day. The management and administrative cost of owning mutual funds, index funds or ETFs is called the expense ratio. A typical expense ratio is between 0.18% and 0.25% for an index fund as compared to about 1.5% for a mutual fund. (For listings of the largest ETFs see Morningstar.)

In March 2006 the New York Stock Exchange became a publicly-traded for-profit company, which began trading under the ticker symbol NYX. In April 2007 the NYSE Group merged with the European combined stock market Euronext to form NYSE Euronext, the world's first global stock market with intentions to trade continuously for 21 hours per day. In October 2008 NYSE Euronext acquired the American Stock Exchange.

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In 1882 Charles Henry Dow founded Dow Jones & Company with his partner Edward Jones. On July 3, 1884 he published his first stock market average composed of 11 stocks: 2 manufacturing & 9 railroad companies (railroads were among the largest & sturdiest companies and industrials were considered more speculative). Dow's purpose in creating an index was to identify trends that could be used to guide investment. He used only closing prices to eliminate the effects of day-trading. (For details concerning DOW theory and technical analysis — see my essay Investing & Trading in Equities: Art & Science.)

On May 26, 1896 Dow created an 12-stock industrial index separate from his 20-stock railroad index. The first DOW industrial price average was 40.94. At first the average was published irregularly, but when THE WALL STREET JOURNAL began being published daily on October 7, 1986, the DOW began being published daily as well. The DOW indexes allowed investors to guage the over-all movement of the market — as opposed to individual stocks — and created the opportunity to compare the movements of individual stocks with the broader market. By choosing only the most heavily-traded stocks it became possible to quote the index intra-day, because all of the stocks would have had recent trade prices.

After Dow's death the Dow Indexes were controlled by THE WALL STREET JOURNAL editors, who expanded the industrial index to 30 stocks by 1928 and added a utility stock index in 1929. The number of stocks in the Dow has remained at 30, even though the individual stocks are changed from time-to-time. Of the original 12 industrial stocks, only General Electric is still in the DOW 30 industrial index.

Currently, the decision concerning which stocks are to be included in the DOW30 is based on the subjective judgement of the WALL STREET JOURNAL managing editor & index editor. In general, the DOW 30 are intended to include the largest & most well-established ("Blue Chip") publically-traded Industrial (meaning not Transportation or Utility) companies in America. Stocks in the DJIA account for just less than 30% of total American equity capitalization. Changes to stocks included in the DOW are infrequent: 3 stocks were added/dropped in 1991, 4 in 1997 and 4 in 1999. The addition of Microsoft and Intel in 1999 was the first inclusion of Nasdaq Market Stocks to the DOW 30.

Unlike other stock market indices, the DOW is not weighted by market capitalization (price times number of shares outstanding). Originally, Charles Dow simply added-up the prices and divided by number of stocks to get a true average. But to preserve historical continuity, the divisor has been continually adjusted — most frequently to account for stock splits. As an example, consider an averaged index composed of 3 stocks selling at $5, $10 and $15. The average price of these stocks would be $10 [(5+10+15)/3]. But if the $15 stock split 3-for-1, the average stock price would suddenly become $6.67 [(5+10+5)/3]. By changing the divisor from 3 to 2 to correct for the split, the average remains $10 [(5+10+5)/2]. Over the years the divisor has become smaller and smaller, falling below 1 in 1986 following a 2-for-1 stock split by Merck. Dividing by a number less than one is multiplication.

To find the current DOW divisor, divide the DJIA by the sum of the prices of the stocks. On Monday, November 15, 2004 the divisor became 0.13532775 — meaning each $1 change in a DOW stock price caused a nearly 7.4-point change in the DJIA. The fact that the DOW is a price-average means that high-priced stocks have a bigger impact on the index. A 10% move in a $100 stock has 5 times the effect of a 10% in a $20 stock. Some analysts think that the greater "weighting" of the more successful (high-priced) stocks in the DOW has a similar benefit as the weighing by market capitalization done for other indices.

The NYSE Composite Index — comprised of all the stocks listed in the exchange — would seemingly be more representative of market activity for America's most established companies, but it is not widely watched. The main reason that the DOW is the most widely watched & quoted index is probably because it has been watched & quoted for so many years. And by being watched & quoted the DOW undoubtedly exerts a disporportionate impact on investor psychology. The ETF for the DJIA is traded on the AMEX under the symbol DIA (known as "Diamonds").

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Securities not listed on a stock exchange (unlisted securities) are mostly traded by dealers in the Over-The-Counter (OTC) market. OTC securities have traditionally been those that are unable to meet the listing requirements of an exchange and therefore must be traded by brokers/dealers directly negotiating with each other by phone or by computer. NASD has the responsibility for monitoring the OTC market.

The National Association of Securities Dealers (NASD) was organized under an amendment to the Securities Exchange Act of 1934 and is supervised by the SEC. NASD regulates through the power to deny membership to brokers/dealers and NASD members are only allowed to do business with other members (banks are not eligible for NASD membership).

The NASD began a nationwide computerized quotation system on February 8, 1971 as a means to automate & expedite trading in the OTC market. NASDAQ is the National Association of Securities Dealers Automated Quotation system. The indexes created by NASDAQ have become proper nouns, with only the initial letter capitalized: Nasdaq.

In contrast to the NYSE, the Nasdaq Stock Market does not require profitability as a requirement for listing and the Nasdaq allows for listing of Initial Public Offerings (IPOs, initial sales of stocks for first-time issuers of stocks). The Nasdaq quickly became a magnet for capital-hungry technology start-up companies such as Intel (1971) and Microsoft (1986). Although many Nasdaq-listed companies have "graduated" to the NYSE, Intel set a precedent of remaining with the Nasdaq, as has Microsoft and Cisco.

The Nasdaq Stock Market is primarily a dealers' market (dealers' quotes rather than auction drives the market), but competition between dealers usually serves to keep spreads low. Additionally, the Nasdaq connects to Electronic Communications Networks (ECNs, such as Island and Reuters' Instinet) which allow individual investors to trade directly with each other electronically — and at all hours. As of 2002 about a third of all Nasdaq trades were being executed on ECNs — up from a quarter of all trades the previous year. (By 2004 one ECN, Archipelago, accounted for nearly an eighth of the entire volume of the US securities market.)

The Nasdaq Composite Index is a market capitalization weighting of prices for all the stocks listed in the Nasdaq Stock Market. (Market capitalization is price per share of stock times the number of shares outstanding.) The Nasdaq Composite began on February 8, 1971 with a base of 100.00. In contrast to the S&P 500 which has about a quarter of its market cap in technology, two-thirds of the Nasdaq Composite market cap is computers, software and telecommunications (telecom) companies.

The Nasdaq-100 Index and the Nasdaq Financial-100 Index were launched on January 31, 1985 with a base of 250.00. The Nasdaq-100 excludes financial stocks and as of December 2002 was about 70% (down from 90% in 2 years) comprised of the largest computer, software and telecom stocks (by market cap) in The Nasdaq Market. On January 1, 1994 the Nasdaq-100 Index was adjusted by cutting the value in half. The Nasdaq Stock Market calculates and disseminates the Nasdaq-100 every 15 seconds during trading hours. Most of the Nasdaq-100 is owned by indexers and QQQ traders (see below). The Chicago Mercantile Exchange (CME) introduced a Nasdaq-100 futures contract in 1996 and added a mini-contract in 1999.

To be included in the Nasdaq-100 a company must have a minimum average trading volume of 100,000 shares per day and must have been trading or a major exchange for at least a year or two. International companies must have a U.S. market value of at least $4 billion. Changes to the stocks comprising that Index are made once per year, at the close of the third trading Friday in December. There is a quarterly review of the weightings of stocks in the Nasdaq-100. If any stock exceeds a weighting in excess of 24% of the Index, that stock's weighting will be adjusted to 20%. If the combined weightings of all stocks with a weighting larger than 4.5% exceeds 40% of the Index, the collective weightings of those stocks will be scaled-down to 40%.

The Nasdaq-100 ETF/UIT (index-tracking stock) was started on the AMEX on March 10, 1999 under the symbol QQQ ("Cubes"). The AMEX later merged with the NASD, the parent of the Nasdaq. On December 1, 2004 the listing was moved to the Nasdaq Stock Market and the symbol was changed to "QQQQ" — while continuing to trade on the AMEX floor on an unlisted trading privileges basis. Price discrepancies between the Nasdaq-100 and the QQQQs are kept to a minimum by arbitrage traders. Operating expenses for the QQQQs are not allowed to exceed 0.20% ($20 per $10,000).

ETFs are popular with hedge funds which (unlike mutual funds) can take short positions as well as long and can leverage their positions (buy or sell on margin). Cubes quickly became by far the heaviest traded ETFs, with one-quarter of the shares sold short in the Spring of 2002. Cubes and other ETFs (Diamonds & Spiders) now trade on the NYSE.

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In 1923 Standard & Poor's introduced an index of stocks of 233 companies which was intended to be an improved measure of American stock market performance. Weekly publication of the index was begun in 1926. In 1928 Standard & Poor's introduced the S&P 90 Composite as an index that could be rapidly calculated. Quotations of the S&P 90 were published first daily and then hourly.

The S&P 500 Index was introduced by McGraw Hill's Standard and Poor's unit in 1957 to further improve tracking of American stock market performance. In 1968 the U.S. Department of Commerce added the S&P 500 to its Index of Leading Economic Indicators. The CME began trading a futures contract based on the S&P 500 in the early 1980s and by the end of the decade the daily value of trade of this contract exceeded the daily value of all stocks traded on the floor of th New York Stock Exchange.

The S&P 500 is intended to be comprised of the 500 biggest publically-traded companies in the United States by market capitalization (in contrast to the FORTUNE 500, which are the largest 500 companies in terms of sales revenue). Although the general principle for calculating the S&P 500 Index on the basis of market capitalization of the largest 500 companies is simple, the details can be complex. (See S&P 500 Index Calculation for details.)

The S&P 500 Index comprises about three-quarters of total American capitalization. In 2001, forty of the S&P 500 stocks provided half of the Index's total market cap. In 1999, nine of the S&P 500 stocks provided half of the Index's total return.

Most money managers treat the S&P 500 as a proxy for the US stock market. Three-quarters of money in American index funds is tied to the S&P 500. Analysts using the Capital Asset Pricing Model (CAPM) use the S&P 500 as a proxy for the stock market — and the standard for calculating beta (ß, market risk, where the S&P 500 has a beta equal to 1.00).

There are both objective & subjective standards for inclusion in the S&P 500 Index. To be included a company must be profitable, a criterion that has excluded Amazon. The prospective company must not be closely-held (at least 50% of its stock should be public) and must have a large trading volume for its shares (no less than a third of its total shares). Although over a tenth of the companies listed on the NYSE are foreign (listed in the form of American Depository Receipts, ADRs, with underlying shares held overseas), these are excluded from the S&P 500. When Daimler-Benz acquired Chrysler in 1998, the new DaimlerChrysler was excluded from the S&P 500 because it wasn't based in the US. In July, 2002 foreign companies that had formerly been "grandfathered" in the Index for decades, such as Unilever (Netherlands) and Alcan (Canada) were removed. Schlumberger (headquartered in the US, but registered in the Antilles) and US companies headquartered in Bermuda (such as Tyco), remained. Companies are usually removed from the Index due to mergers, acquisitions, bankruptcy or a significant drop in market cap. Companies removed from the S&P 500 suffer an average 12% loss between the announcement of removal and the removal, relative to the Wilshire 5000, but these losses mostly vanish within six months.

The subjective criteria are in the heads of the committee that meets monthly in New York City to review the stocks comprising the S&P 500. The meetings are held in secret and minutes are not released to the public. Inclusion or exclusion of a stock from the Index can have a dramatic effect on stock price because Index Funds typically buy more than 5% of a newly-listed company's outstanding shares between the announced inclusion and the inclusion. An announcement is made at 5:15pm (after market close) five days before inclusion/exclusion in the S&P 500. In the late 1990s the S&P 500 committee showed a distinct bias toward the inclusion of technology stocks, to reflect their "up-to-date" attunement with the "New Economy" — bringing tech stocks to roughly a quarter of the S&P 500 total value. Price/Earnings ratios (P/Es) were not a factor in making these inclusions, which resulted in the S&P 500s P/E average rising well above historic levels.

The ETF/UIT for the S&P 500 are traded on the AMEX under the symbol SPY, but the nickname "Spiders" comes from the name Standard and Poor Depositary Receipt (SPDR). Second in trading volume (nearly a third) only to the Cubes, Spiders (the first ETF) were created over half-a-decade earlier — on January 1993, priced per share at one tenth the value of the S&P 500 Index. The Vanguard 500 Index Fund tracks the S&P 500 Index, but with a lower expense ratio than other index funds.

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The Russell 1000, Russell 2000, and Russell 3000 Indices were created in 1984 by investment consulting firm Frank Russell Company of Tacoma, Washington. The Russell 3000 Index is comprised of the largest 3,000 American domiciled publically-traded corporations as of May 31st of each year, rated by market capitalization. Unilever, Schlumberger, Seagrams and all other foreign-domiciled companies are excluded. Also excluded are corporations whose share price is less than $1. The Russell 3000 Index is rebalanced annually on June 30, along with the Russell 1000 and the Russell 2000. The Russell 3000 Index represents about 98% of the total market cap of all American domiciled corporations. Unlike the Wilshire 5000, which attempts to include all the (more than 5,000) shares of publically-traded companies into an index, the Russell 3000 focuses on 3,000 frequently-traded stocks as a way of creating a more accurate and readily-updated index.

The Russell 3000 is divided into the Russell 1000 and the Russell 2000. The Russell 1000 Index comprises the largest 1,000 companies in the Russell 3000, representing about 92% of the Russell 3000 market cap. The Russell 2000 Index comprises the 2,000 smallest companies in the Russell 3000, representing about 8% of the Russell 3000 market cap. Despite the large number of stocks in the Russell 2000, the Index is no less vulnerable than the others to a disproportionate influence from a few exceptional performers. In the June 30, 1999 to February 11, 2000 period the Russell 2000 advanced 17%, half of which was due to only 13 stocks [BARRON'S, 21-Feb-2000, page 40].

The Russell 2000 Index is far more widely watched & used than the Russell 3000 or Russell 1000. The Russell 2000 Index is widely accepted as representing the "small cap" portion of the US stock market.

The ETF/UITs traded for the Russell 2000 are mostly iShares, creations of the San Francisco-based Barclay's Global Investors unit of the British Barclay's Bank. Russell 2000 iShares trade on the AMEX under the symbols IWM, IWN and IWO — for the total-market, value and growth portions of the Russell 2000, respectively. Merrill Lynch has less widely-traded ETFs for the Russell 2000, which are listed on the AMEX under the symbols RSM & RUM.

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The Wilshire 5000, is intended as an American "total market index" of all American stocks traded on a stock exchange. Penny stocks are excluded. When the index was started there were about 5,000 such stocks, but by 2009 the number was close to 6,300 . About 90% of the market value is in large cap stocks , with the smallest included company having a market capitalization of about one million dollars.

The market capitalization of stocks in the Wilshire 5000, but not in the Russell 3000 amounts of only about an additional 2%. The fact that the Wilshire 5000 is a market-capitalization weighted index means that the additional 2% have a nearly negligible effect on the index. Including so many stocks results in high transaction costs and high administrative costs, ie, high expense-ratios for funds based on this index. Nonetheless, the Vanguard Total Stock Market VIPERs (Vanguard Index Participation Equity Receipts) is a low expense-ratio ETF which tracks the Wilshire 5000 (stock symbol VTI).

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