How an index is built, why a few top stocks dominate it, how its makeup changes, and the tracking error and premiums of products that follow it.
An index expresses the price change of a rule-selected basket of stocks as a single number. Which stocks are included and how much each counts are set by rules. The most common approach weights by company size, so price changes in large companies move the index more.
In a size-weighted index, the top few constituents account for a large share of the movement. That is why days occur where the index rises while most stocks fall. It is worth knowing that 'the market rose' is not the same statement as 'most companies' shares rose'.
An index is not a fixed list; constituents enter and leave periodically by rule. Companies failing the criteria drop out and newly grown ones enter. Long-run index performance therefore includes the effect of the surviving and growing companies remaining. It is one reason holding an individual stock differs from tracking an index.
Funds and listed products exist that follow an index directly. Their characteristic is resolving in one holding what would otherwise mean buying many stocks and maintaining weights. Products differ in which index they follow and in total expenses and actual tracking difference, though. Similar names can hold different things, so check which index is tracked.
Look at which index it tracks, total expenses, how far it has actually diverged from the index, and whether size and trading volume are sufficient. Products using derivatives to move at a multiple of an index are a different kind of instrument and are frequently unsuited to long holding. This explains the structure and recommends no product.
In Korea, the main indexes are KOSPI, covering the whole main board, and KOSDAQ, covering the KOSDAQ market, with separate indexes built from large caps. In the US, commonly cited ones are the S&P 500, which holds around 500 large companies, the tech-heavy NASDAQ family, and the Dow, calculated from the prices of 30 stocks. Because the Dow is price-weighted, it can move differently from cap-weighted indexes on the same day. Japan has broad indexes such as TOPIX. Index names may all seem to point to 'the market', but what they hold, how many, and how they weight it determine their character.
Products that follow an index don't move exactly in line with it. Fees are deducted daily, dividends are received and reinvested at different times, and reflecting constituent changes incurs trading costs. The gap between a product's return and the index's is called tracking error. Listed products have one more gap: their market price can differ from the value of the assets they actually hold, the net asset value. This premium or discount tends to widen in thinly traded products or those holding foreign assets. Fund managers publish both figures on their websites, so check them together.
Index products are simple in structure, and the misconceptions about them are simple too. It's easy to think that following an index means no losses, but when the index itself falls sharply, the product falls with it. Products carrying the same index name can differ in whether they hedge currency risk and whether they pay out or reinvest dividends. Products designed to move at twice the index or in the opposite direction reset to a daily return, so held for long periods their results can diverge greatly from that multiple of the index's return. Check these differences in the product documents before choosing. This guide explains structure and recommends no product.
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