Stock market indexes provide a convenient way of capturing the general mood of the financial markets and are widely quoted and followed. Current and recent values of the key averages and indexes are quoted daily on financial websites, in the financial news, in most local newspapers and on many radio and television news programs. They are used as performance benchmarks for actively managed accounts and funds. They also take the form of investments through index funds and Exchange Traded Funds (ETFs) which attempt to replicate their performance.
The notion that increased passive investing may lead to heightened correlations in prices raises the importance of diversification beyond passive investment products.
One of the most profound developments in the stock market in the last two decades has been the growth of indexed based investments and the increasing prevalence of passive fund management. Though the assets of traditional mutual funds have increased three-fold in the last 17 years, the assets of ETFs, funds that are typically indexed, have grown 130-fold.
The oft-cited Standard & Poor's 500 Index has become the benchmark for estimating or calculating the “market return” and is comprised of 500 large companies (not necessarily the largest) weighted by the market value of each stock in the index. The problem with capitalization weighted indexes is that larger capitalization stocks can make the index vulnerable to concentration risk. As a company outperforms its index, its relative weight in the index will increase. Given the number of ETFs and index funds that are tied to the S&P 500, this becomes a circular and expanding problem.