How to calculate the early return index
The index - what is a stock index?
An index shows the performance of a certain selection of fixed values, such as stocks or bonds. Such stock market indices serve as a barometer for a representative selection of securities of a geographic region, a branch or a certain quality class. For example, the German share index (DAX) is a key figure that shows the share price development of the 30 largest and most liquid companies in Germany.
In addition to indices on stocks or bonds, there are also indices on other asset classes or key figures. There are, for example, indices on raw materials, currencies, on the volatility of a stock index (volatility index) and on consumer prices, real estate prices or the inflation rate. What these different types are used for and how a private investor can use them is explained below.
Indices in practice
For investors, indices on securities serve as stock market barometers for individual economies or economic sectors. Another function of stock market indices is to provide the performance of a portfolio, which is made investable for investors through financial products. Because a direct investment in the index is not possible. Some examples of financial products that investors can use to invest indirectly in an index are: Exchange-Traded Funds (ETFs), index funds, index certificates, futures contracts, options, warrants, Contract for Differences (CFDs).
An index serves as a benchmark for fund managers to check whether they are successful with their strategy.
Overview of indices
The following overview is an overview of the most important indices from different countries for different asset classes:
DAX - German share index. The DAX is the most important leading index for the German economy. It represents the 30 largest listed companies in Germany.
TecDAX - the TecDAX consists of the 30 largest, listed technology companies from Germany.
MDAX - The MDAX represents the 60 largest companies in Germany, following the companies included in the DAX in terms of size. It can therefore be seen as a barometer for medium-sized, listed companies in Germany.
European stock indices
EURO STOXX 50 - The EURO STOXX 50 shows the performance of the 50 largest listed companies in the euro area. It is therefore one of the most important stock market barometers for the euro zone.
STOXX Europe 600 - The STOXX 600 consists of the 600 largest European stock corporations and thus represents the entire European economy.
FTSE 100 - The FTSE 100 is considered to be the leading index for the UK stock market. It is made up of the 100 largest and top-selling UK companies listed on the London Stock Exchange.
CAC 40 - The CAC 40 represents the 40 top-selling French companies that are traded on Euronext Paris.
FTSE MIB - the FTSE MIB is made up of the 40 most important Italian companies listed on the Milan Stock Exchange.
Stock indices worldwide
Dow Jones - The Dow Jones Industrial Average is one of the oldest American stock indices and is made up of the 30 largest US companies. Since the Dow Jones is price-weighted, large companies are underweighted in the index and small companies are overweighted. Because of this weakness, the S&P 500 is usually used as a barometer for the US economy, as it is calculated on a market value-weighted basis and takes more companies into account. This weakness is also addressed by the researchers John B. Shoven (Stanford University and National Bureau of Economic Research) and Clemens Sialm (Stanford University).
S&P 500 - The S&P 500 is considered to be the leading index for the US economy. It represents the 500 largest US publicly traded companies.
Nikkei 225 - The Nikkei 225 is the leading index for the Japanese economy and is made up of the 225 Japanese companies that are traded on the Tokyo Stock Exchange.
SSE composite - The SSE Composite is the leading index for China and consists of all companies that are listed on the Shanghai Stock Exchange.
MSCI World - the MSCI World represents over 1,600 listed companies from 23 industrialized countries. It is considered the leading index for the economies of industrialized countries.
MSCI EM - the MSCI Emerging Markets Index consists of around 850 public companies from 26 emerging countries, such as China, South Korea, Taiwan, India, South Africa and Brazil
MSCI AWCI - the MSCI All Country World Investable Market Index comprises listed companies from industrialized and emerging countries. In addition to large companies, this index also includes smaller companies around the world. With around 8,500 companies, it is a very broad stock index.
Bond / bond indices
Bloomberg Barclays Bond Indices - The Bloomberg news service provides a variety of bond indices for different economic areas and grades (from government bonds to high-yield bonds). For example, the Bloomberg Barclays Global Aggregate Bond Index tracks the performance of government and corporate bonds around the world.
Iboxx - Iboxx is the name of an index family of bond indices. The liquid indices, which focus only on bonds traded in liquid form, are particularly popular.
Bloomberg Commodity Index - The Bloomberg Commodity Index tracks the performance of 23 commodity futures contracts. The weighting of the individual raw materials is based on the production of the raw material and the liquidity of the corresponding futures.
Rogers International Commodity Index - the Rogers International Commodity Index tracks the performance of 37 commodity futures. The weighting of the individual raw materials is based on global consumption.
Stock exchanges, banks, rating agencies, news services and specialized index providers act as providers of indices. The main index providers include:
MSCI - Morgan Stanley Capital International is a US financial services company that calculates many stock indices, such as the MSCI World, the MSCI Emerging Market and the MSCI All Country World Index.
Standard & Poor’s - Standard & Poor’s is primarily known as one of the most important rating agencies. In addition, Standard & Poor's provides stock indices, such as the S&P 500. In addition to many other stock indices for regions and industries, S&P also calculates a commodity index, the S&P GSCI (Standard & Poor's Goldman Sachs Commodity Index), formerly owned by Goldman Sachs was offered.
FTSE Group - the company specializing in stock indices was founded as a joint venture between the Financial Times newspaper and the London Stock Exchange and is now a subsidiary of the London Stock Exchange. In addition to European stock indices (e.g. FTSE 100 and FTSE MIB), FTSE provides many international and industry-specific indices.
STOXX AG - STOXX is an index provider of Deutsche Börse. In addition to the EURO STOXX 50 and the STOXX Europe 600, STOXX offers many other stock indices.
Originally, the primary source of income for index providers was selling index data and licensing derivatives such as futures and options. Nowadays, however, they mostly make their living selling licenses on their indices to ETF providers. Because in order to be able to offer a well-known index as an ETF, the ETF provider needs a license.
Calculation of indices
The calculation of an index usually begins with an even number such as 1000 or 100 at the start time. The further calculation is based on the development of the values contained in the index. The inclusion of values or countries in an index is based on certain criteria. For example, only companies are included in the DAX that are among the largest companies in Germany in terms of market capitalization and stock exchange turnover and whose free float is greater than 10%, i.e. not held by major shareholders. The three selection criteria of market capitalization, stock exchange turnover and free float are the most important criteria for almost all stock indices, while more specific stock indices use completely different criteria. For example, for a stock index that tracks the performance of sustainable companies (Sustainability Index), ecological aspects play an important role. For an index that includes companies from several countries, in addition to the size and liquidity of the companies, the general economic development of a country and market access for foreign investors are also important.
There are three different approaches to taking the development of the index values into account for securities:
- Price index - only the prices of the securities are shown when calculating the index. Further returns from dividends, interest and other sources of income are ignored.
- Total return index(Performance index) - In addition to the prices of the securities contained in the index, dividends, interest and other sources of income are also taken into account in the performance.
- Total Net Return Index - the calculation is almost identical to the total return index, with the difference that fictitious taxation on dividends and investment income is taken into account.
Furthermore, there are different ways for indices to weight the individual values in the index. The three usual methods of weighting for stock market indices are as follows:
- Price-weighted index - Share prices of all index values are added up and then divided by the number of index values (e.g. Dow Jones and Nikkei 225).
- Market value weighted index - The weighting of the individual values is based on the market value of the security. This is the most common method for calculating the performance of stock indices.
- Balanced index - In the case of an equally weighted index, all index values contained therein are represented with the same percentage weighting. In order for this weighting to remain constant over time, a regular reset to the original ratio is necessary.
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