How the market is built: indexes and ETFs
When someone says “the market was up today”, they almost always mean an index. Understanding how indexes are built tells you a lot about what you actually own when you buy “the market”.
What an index is
An index is a rulebook for choosing and weighting a basket of stocks, then tracking its value. The S&P 500 holds roughly 500 large US companies. The FTSE 100 holds the 100 largest companies listed in London. The Nasdaq 100 holds the 100 largest non-financial companies on Nasdaq.
Market cap: how big is a company?
Market cap = share price × shares outstanding
Market capitalisation is what the market says the company’s equity is worth. Companies are often grouped by it: large caps (roughly $10bn and up), mid caps and small caps. Enterprise value goes a step further (market cap plus debt minus cash) and estimates what it would cost to buy the whole business, debts included.
Weighting: the detail that matters
- Market-cap weighted (S&P 500, FTSE 100): bigger companies get bigger weights. The most common approach.
- Price weighted (Dow Jones): a $500 stock counts more than a $50 one, regardless of company size. A historical quirk.
- Equal weighted: every company gets the same share. More exposure to smaller names.
Cap weighting means index returns are driven by the biggest names. In recent years a handful of US tech giants have made up over a third of the S&P 500. Buying “500 companies” is far more concentrated than it sounds.
It also explains the FTSE 100’s character. It is heavy in banks, energy, miners and consumer staples, and most of its companies’ revenue comes from outside the UK. It is not a bet on the British economy.
ETFs: buying the index
An exchange-traded fund is a fund that trades on an exchange like a single share. Most track an index. One purchase gives you a slice of every company in it, usually for a small yearly fee (the expense ratio).
The clever bit is how the price stays close to the value of what the fund holds. Large dealers called authorised participants can create new ETF shares by handing over the underlying stocks, or redeem ETF shares for them. If the ETF trades above its holdings, they create and sell. If it trades below, they buy and redeem. That arbitrage keeps the gap tiny.
Beyond plain index funds
There are ETFs for sectors, countries, bonds, commodities and strategies. Leveraged ETFs (2x, 3x) reset daily, so over longer periods they can lose money even when the index ends up flat. They are trading tools, not long-term holdings.
Key takeaway
An index is a set of rules, not “the economy”. Know how it is weighted and what it is heavy in before treating it as your benchmark.
Educational content only, not financial advice. Investing involves risk and you can lose money.