A share market index is intended to give investors an idea of the overall movement in prices of a group of shares. An index can literally include all of the shares traded on a stock exchange (e.g. such as the JSE Allshare Index), or can represent a selection of just some of the shares (e.g. the JSE Top40 index). (To be precise, the JSE All Share and other sectoral indices exclude some thinly-traded (i.e. infrequently traded) shares, as well as some shares with a very low market capitalization. However, the “99% Rule” imposed by the JSE says that the All Share Index must represent at least 99% of the market capitalization of all of the shares traded on the JSE).

Most indices are weighted, based on the market capitalization of the underlying shares. We can use a simple example to explain this. Let us say that the JSE wishes to establish an index on a particular day, consisting of the shares of 3 different companies. Let us also assume the following data pertaining to these shares at the end of Day 1:

(The market capitalization is equal to the number of shares issued by the company, multiplied by the share price at which the share is trading on the stock exchange).

We will assume that the index on Day 1 is set at 1000. (This is an arbitrary number. It just serves as a base level, against which future movements will be measured).

Let us then say that, at the end of Day 2, the following applies to our 3 shares:

The index on Day 2 would then be: (R5400/R5200) x 1000 = 1038

This means that, on average, the value of the 3 shares has increased by 3.8% in the last day. Also, because share A has the most number of shares available for trading, and has the highest share price, a R1.00 movement (increase or decrease) in A’s share price will affect the index more than a R1.00 movement in C’s share price. We can also say that, on Day 2, share A makes up 61.1% of the index. (R3300/R5400) x 100/1

Indices have become important not just because they can indicate the average direction in which the stock market is moving (via the Allshare index), or the direction in which a particular sector is moving, but also because they form the basis of some unit trust funds. These unit trust funds are called Index Funds. The managers of these funds try to make sure that their fund is made up of all of the shares which make up a particular index, and in the same weighting as their weighting in the index. Then, when the index goes up by 2%, unit trust owners know that the value of their units has also increased by 2%.

These funds have become popular because most “active” unit trust managers, even though they carefully select the shares in their portfolio, cannot produce better returns than the average returns from the stock market as a whole. (Particularly in the long run). So, by investing in an index fund, you are pretty much guaranteed to do better than about 80% of active fund managers. It is not as exciting as investing in individual shares, or in high-risk unit trust funds, but you tend to sleep a lot better at night! (And probably end up wealthier as well).

It is important to note that most indices reflect changes in share prices only – they don’t include any dividends paid out by their constituent companies. When you calculate your personal returns you are likely to include dividends received, which therefore does not allow for a fair comparison with market returns as measured by changes in the All Share index. Some indices are in fact adjusted for cash dividends received, as described later in this article.

1. Capped Index

What quite often happens is that, as companies grow and mature, their returns slow down (i.e. the growth in their share price slows down). However, these large companies can make up a large percentage of the market index (such as Company A in our little example), so if you are invested in a normal Allshare index fund, you will end up with a large investment in these particular companies.

A capped index fund tries to overcome this problem. A 10% capped index fund means that no share can make up more than 10% of the weighting of the index. (So our share A, at 61.1%, would be way over the limit.) So, when first establishing a capped index, all companies making up more than 10% of the index would have their value cut down to 10% (on the basis of their market capitalization). These weightings are reviewed on a regular basis (e.g. quarterly), and any share that makes up more than 10% of the total index will have its value cut back to 10% of the index in total, and the index will then be recalculated.

1. Shareholder weighted indices

The normal stock market indices, as described above, reflect changes in the prices of the underlying shares making up the particular index. A change in the share price affects the return to the shareholder. For instance, if you buy a share for R100 at the beginning of the year, and at the end of the year it is trading at R110, you are regarded by the investment fraternity as having made a return of 10% on your investment as a result. (The share price has grown by R10, which is 10% of your original investment of R100). They conveniently ignore the fact that, strictly speaking, you only earn that return when you sell the share.

“Normal” indices therefore show the returns made as a result of share price increases only. (Negative returns can be made by share price decreases. When we talk about returns, these could therefore be either positive or negative. To keep things simple, we will focus only on positive returns.)

In actual fact, shareholders also earn returns from dividends. (A company can re-invest its profits into the business, to grow the business, in which case the share price should increase. On the other hand, it may choose to pay out some of its profits to shareholders as dividends, and re-invest the rest into the company. In this case, growth in the share price should be lower than if no dividends were paid). However, as mentioned above, “normal” indices ignore the effect of dividends on shareholder returns.

A shareholder weighted index (or shareholder value weighted index) is a “normal” index, but adjusted to also take into account the effect of cash dividends paid to shareholders. Movements in a shareholder weighted index therefore reflect total returns to shareholders, and not just those returns represented by an increase in the share price.

For instance, to expand on our earlier example, if you buy a share at R100 at the beginning of the year, it is trading at R110 at the end of the year, and you receive a cash dividend of R4 at the end of the year, your total return on that share for the year is 14% (R10 share price growth + R4 dividend =R14, which is 14% of the R100 you paid at the beginning of the year).

The shareholder weighted index will reflect that 14% return, and not just the 10% return from the share price growth.