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Business Matters The truth about indexes

February 16, 2011

By Staff Reporter

By Kevin Fitzgerald

I’ve just started to receive my year-end statements from the various mutual fund companies. I’m not exactly sure how the various indexes work and which one to use to gauge how my portfolios are doing. Can you give me some help?

— P.M., Manhattan

There is more to the stock market than just the Dow. Although that may sound obvious, it warrants comment from those investors who are disconcerted by the current ups and downs of the Dow Jones Industrial Average. Without negating the significance of these shifts for those who invest in the 30 stocks that make up the Dow, let’s review all the indexes from the perspective of investors with diversified portfolios. First, a few basics:

What is an index?

An index is a composite of securities designed to replicate the structure and performance of a specific segment of the financial markets. Market indexes are developed and used as comparative measurements for the performance of securities with similar investment style attributes. The most commonly quoted index is the Dow Jones Industrial Average.

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What is the Dow?

In 1884, Charles Dow compiled a list of 11 stocks, nine railroads and two manufacturing firms. The average of the closing prices of the stocks was posted in a financial bulletin that he published with his partner, Edward Jones. The financial bulletin was the forerunner of The Wall Street Journal, and Dow’s list of stocks evolved into the Dow Jones Industrial Average.

Today there are actually four Dow Jones Averages In addition to the Industrial Average, there are: the Transportation Average, which consists of 20 airlines, railroads and trucking companies; the Utility Average, comprising 15 gas, electric and power companies, and the Dow Jones Composite Average, which includes all 65 companies that make up the other three averages.

It is the Dow Jones Industrial Average that is reported on television, radio and in newspapers during their daily stock reports. However, today the Industrial Average monitors 30 key industrial companies, which account for about 15 percent of the total value of all U.S. stocks.

The Dow is a price-weighted index, which means that component stocks are accorded relative importance based on the price per share of their stock. Consequently, higher-priced stocks have a greater percentage impact on the index than lower-priced stocks. If there is a sharp increase in the price of one of the stocks that make up the Dow, it can push the Dow index to highs while other market-weighted indexes languish.

More measures than the Dow

Although the Dow may be the most widely reported index, there are others that measure many broader market sectors. There are indexes for domestic stocks, foreign stocks, large companies and small companies, domestic bonds, foreign bonds, long-term bonds, short-term bonds, etc.

If you have diversified your portfolio by choosing securities in various asset classes (stocks, bonds and/or cash reserves) and investment styles, you should not look exclusively at a general index like the Dow Jones Industrial Average to fairly measure the performance of your securities. For the most accurate evaluation, you should view your portfolio in the context of each of the different investment styles that it includes. There are indexes that can provide measurement for both a very broad or a very narrow market segment. For example"

€ The Standard & Poors 500 (S&P 500) index is a broader market measurement than the Dow. The companies that comprise it account for nearly two-thirds of the value of all stocks traded in the U.S. It monitors 400 industrial companies, 20 transportation companies, 40 utilities and 40 financial companies. Among these are the 30 Dow industrial companies. The S&P 500 is a market-weighted index, which means that each stock is weighted according to the total market value of its outstanding shares. Therefore, the stocks of larger companies have a greater impact on the performance of the index than the stocks of smaller companies. The S&P 500 is often considered a benchmark for large-company stock investors.

€ The Nasdaq Composite index, also known as the over-the-counter index, includes the 5,499 stocks traded on the Nasdaq. These stocks make up over 17 percent of the value of all U.S. stocks traded. Like the S&P, the Nasdaq is a capitalization-weighted index, so the bigger companies tend to dominate the index.

Since the Nasdaq index includes over 700 technology stocks, which account for over 37 percent of the index, the Nasdaq may also provide the most accurate measurement of technology stock performance.

The New York Stock Exchange Composite index monitors 2,834 stocks, including most of the S&P 500, representing over 82 percent of the value of all U.S. stocks. The New York Stock Exchange Composite, like the Nasdaq, is a capitalization-weighted index.

€ The Russell 3000 follows the 3,000 largest American stocks. It includes only common stocks within the U.S. and its territories. Their combined value accounts for 98 percent of the total value of all U.S. stocks.

€ The Russell 1000 monitors the 1,000 largest U.S. companies, and although it represents one-third of the stocks monitored by Russell, it accounts for 90 percent of the value of the Russell 3000. This is a good indicator for the U.S. large-company stock investor.

€ The remaining two-thirds of these companies are monitored by the Russell 2000. The value of these stocks represents the remaining 10 percent of value of the Russell 3000. The Russell 2000 is considered representative of U.S. small- and mid-size company stocks.

Like the Dow, the Russell indexes are price-weighted indexes. All other Russell indexes are subsets of the Russell 3000 Index.

If you want to measure the performance of fixed-income securities, you have another universe of indexes from which to choose. A fixed income investment should be compared to the appropriate bond index depending on the type of bond and its maturity.

For example:

€ The Salomon Brothers Broad Investment Grade Bond index measures the monthly, market-weighted total return of all Treasury, agency, investment grade or better corporate, and mortgage-backed securities that have a stated maturity of one year or longer and with at least $25 million outstanding.

€ The Lehman Brothers Government/Corporate Bond index measures the monthly, market-weighted total return of all Treasury, agency and investment grade corporate bonds with maturities of greater than one year and with a minimum of $1 million outstanding.

This is a much-abbreviated sample of indexes for each specific segment of the financial markets. When measuring investment performance, it is important to use the appropriate comparative indexes in order to make a meaningful evaluation.

The information contained herein has been obtained from sources believed to be reliable, but we cannot guarantee its accuracy or completeness. Neither the information nor any opinion expressed constitutes a solicitation for the purchase or sale of any security.

Kevin FitzGerald is First Vice President-Investments at Paine Webber. He focuses on the areas of professional money management, asset allocation and retirement planning. He can be reached at 1 (800) 654-6162, ext. 448.

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