Correlation Increase Between Returns on Stock & Returns on Index

by Vicki A. Benge, studioD

A stock index may be used as a benchmark to keep abreast of and review stock trading throughout the day or over time. Index funds are mutual funds that own the stocks a particular index tracks. Exchange-traded funds mirror a particular stock index by purchasing and holding shares of stocks that make up the index. An increase in returns on the stocks tracked by the index has a direct reciprocal relation to the returns on an index fund as a whole.

Index Methodologies

The correlation between an increase in returns on stocks within an index and the index value as a whole depends on the methodology used to calculate the index — particularly how the values within the index are weighted. For example, two of the three major U.S. stock indexes, the Nasdaq Composite and the S&P 500, are weighted by market capitalization of the component companies. The third, the Dow Jones Industrial Average is a price-weighted index.

Price-Weighted Results

To understand how a price-weighted index works, consider an index that tracks only 10 stocks. Suppose when the index tracking is initiated, each of the 10 stocks is worth $10 each. Fluctuations in share prices of each of the 10 stocks would have a similar effect on the index and on returns on a fund that tracked the index. Conversely, if one stock holds a current market value of $100 and the remaining nine are selling at $10 per share, a $2 change in the price of the $100 stock would have much less of an impact on the correlation of the index returns than would a 20 percent, or $2 change of value in a $10 stock.

Market Cap Index

In an index such as the Nasdaq Composite or S&P 500, where the values of each stock in the index are based on market capitalization, the resulting correlation between the returns on individual stocks and returns on the index fund as a whole will depend on which stocks carry the most weight. Weight refers to the value a stock is given relative to the value of all others in the index. For example, as of late December 2011, in the S&P 500, Exxon Mobil Corp. made up slightly more than 3.5 percent of the index value. Therefore, a significant change in returns on Exxon Mobil stock would result in a noticeable correlative increase in a fund tracking the index as a whole.

Weighted Values

Comparatively, the top 10 holdings in the S&P make up more than 20 percent of the total market capitalization. Thus, an increase in the returns of these 10 stocks will cause a reciprocal or correlated increase in returns on the index, resulting in a more noticeable change than returns on stocks holding less weight in the index.

About the Author

Vicki A Benge began writing professionally in 1984 as a newspaper reporter. A small-business owner since 1999, Benge has worked as a licensed insurance agent and has more than 20 years experience in income tax preparation for businesses and individuals. Her business and finance articles can be found on the websites of "The Arizona Republic," "Houston Chronicle," The Motley Fool, "San Francisco Chronicle," and Zacks, among others.

Photo Credits

  • Goodshoot/Goodshoot/Getty Images