10/01/2024

2024 CFA L1: Lecture Notes

Equity Analysis
LM 2: Security Market Indexes

LEARNING OUTCOME STATEMENTS • Describe uses of security market indexes.

• Describe a security market index. • Describe types of equity indexes.

• Calculate and interpret the value, price • Compare types of security market
return, and total return of an index. indexes.

• Describe the choices and issues in index • Describe types of fixed-income indexes.
construction and management.
• Describe indexes representing alternative
• Compare the different weighting methods investments.
used in index construction.

• Calculate and analyze the value and return

of an index given its weighting method.

• Describe rebalancing and reconstitution of

an index.

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Security Market Index

Security market index – A group of individual securities chosen to represent a

given security market, market segment, or asset class.
Each security market index may have two versions depending on how returns
are calculated; for example:
• Price return index – Reflects constituent security prices.
• Total return index – Reflect constituent security prices and assumes
reinvestment of all income received since inception.
At inception, both the price and total return indexes have the same value. As
time passes, the value of the total return index accelerates past the value of the
price index.

Price Return Index – Value Calculation

Constituent – A company with securities that have been included in an index;

a security which has been included in an index.

Divisor - A number chosen at inception to give the index a

convenient starting value (e.g., 1000).

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Price Return Index – Single Period Returns

Price return – Measures only the percentage change in price.

The price return of the index equals the weighted-average price return of the
constituent securities.

Price Return Index – Total Return Index

Total return - Measures the percentage change in price plus interest,

dividends, and other distributions.
The total return of each constituent security is calculated as:

The total return of the index equals the weighted-average total return of the
constituent securities. It is calculated as:

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Return Over Multiple Periods

Given price returns for an index over several periods, the value of the price
return index at the end of that time uses geometrically linked periodic returns.

Practice Question

A total return index had returns of 12.6% in 2021 and 13.4% in 2022. Given
that the index value at inception is 1,000, the value of the total return index at
the end of 2022 is closest to:
A. 1026
B. 1134
C. 1277

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Practice Question

A total return index had returns of 12.6% in 2021 and 13.4% in 2022. Given
that the index value at inception is 1,000, the value of the total return index at
the end of 2022 is closest to:
A. 1026
B. 1134
C. 1277
Answer: C
Using geometric linking, index value at the end of 2022 = 1,000 × 1.126 × 1.134
= 1,276.884

Index Construction

Target Security Re-

Market Weighting* constitution

Investable % of each Replace non-

universe security in the conforming
Security index. Rebalancing constituents.
--------
• Asset Class
Selection -------- Criteria
• Geography • Price weight
• Exchange Representative • Equal weight How often and
sample, census, • Market cap why?
% of target market • Fundamental
--------
# may vary to
reflect changes in
the target market

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Price Weighting

Price-weighted index - The weight of each constituent security is calculated

by dividing its price by the sum of the prices of all constituent securities:

Advantage: Simplicity.
Disadvantages: Stock splits and stock dividends change the weights of all
securities in the index. Price-weighted indexes suffer from a downward bias.

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Example: Price-Weighted Index

A price-weighted equity index consists of one share each of five securities. The
prices of these securities at the end of 2008 and 2009 are given below:

1. Calculate the value of the index at the beginning of 2009.

2. Calculate the weights of each security at the beginning of 2009.
3. Calculate the price return of the index for 2009.

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Example: Price-Weighted Index (cont.)

1. Value of the index at the beginning of 2009:

2. Weight of security A = 30/185 = 16.22%

Weight of security B = 22/185 = 11.89%
Weight of security C = 35/185 = 18.92%
Weight of security D = 50/185 = 27.03%
Weight of security E = 48/185 = 25.95%

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Example: Price-Weighted Index (cont.)

3. Value of the index at the end of 2009:

Price return of the index for 2009

= (38.2 – 37)/37 = 3.24%

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Example: PWI Divisor Adjustment

A price-weighted market index includes four stocks: A, B, C, and D. Stock B
issues a four-for-one stock split. The table below lists the prices of the stocks
before and after the split.

If the divisor is not adjusted for the stock split, the index will fall from 60 to 45
(180/4) even though there has been no change in prices other than to adjust for
the split. To reflect the fact that stock values really have not changed, the index
divisor must be adjusted. This new divisor, x, is calculated as (40 + 20 + 70 +
50)/60 = 3.
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Practice Question

A price-weighted equity index consists of three securities whose year-end

prices and number of shares outstanding are given below:

The total return on the index is closest to:

A. –11.11%.
B. –10.42%.
C. 12.50%.

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Practice Question

A price-weighted equity index consists of three securities whose year-end

prices and number of shares outstanding are given below:

The total return on the index is closest to: Answer: C

Index 2014 = [20 + 50 + 50]/3 =
A. –11.11%.
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B. –10.42%.
Index 2015 = [30 + 25 + 80]/3 =
C. 12.50%.
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Return = [45/40] – 1 = 12.50%
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Equal-Weighted Index

Equal-weighted index – At inception, each constituent security is given an

identical weight.

Dividing the value allocated to each security by its share price determines the
number of shares to include. Weights are decided by the index provider in
selecting the number of securities in the index.
Higher market-value companies are underrepresented and vice versa. The
index requires rebalancing after any security price changes.

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Example: Equal-Weighted Index

An equal-weighted equity index with an initial value of 10,000 consists of five

securities whose prices at the end of 2008 and 2009 are given below:

1. Calculate the number of shares of each security included in the equal-

weighted index.
2. Calculate the index value at the end of 2009.
3. Calculate the price return of the index for 2009.

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Example: Equal-Weighted Index (cont.)

Since the index consists of five securities, each security will be assigned a
weight of 20% in the index. As the total value of the index is 10,000, the value
assigned to each security will be 2,000.
1. Number of shares of Stock A = 2,000/30 = 66
Number of shares of Stock B = 2,000/22 = 90
Number of shares of Stock C = 2,000/35 = 57
Number of shares of Stock D = 2,000/50 = 40
Number of shares of Stock E = 2,000/48 = 41

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Example: Equal-Weighted Index (cont.)

2. The value of the index position in each security at the end of 2009 is:
Security A: 66 × 34 = 2,244
Security B: 90 × 28 = 2,520
Security C: 57 × 31 = 1,767
Security D: 40 × 54 = 2,160
Security E: 41 × 44 = 1,804
The total value of the index at the end of 2009 is:
2,244 + 2,520 + 1,767 + 2,160 + 1,804 = 10,495
3. The price return of the index for 2009 = (10,495 / 10,000) – 1 = 4.95%

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Market Capitalization Weighting

Market-capitalization-weighted (value-weighted) index - The market value of

each constituent’s stock to the market value of all constituents’ stocks.

The initial market value is assigned a base number (e.g.,1000) and a new
market value is computed periodically.
The index return is measured by comparing the new market value to the
previous market value or base market value.

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Example: Market Capitalization-Weighted Index

A market-capitalization-weighted equity index consists of five securities whose

prices and number of shares outstanding are given below:

1. Calculate the weight of each security in the index at the beginning of 2009.
2. Calculate the value of the divisor that gives an index value of 1,000 at the
beginning of 2009.
3. Calculate the price return of the index for 2009.

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Example: Market Cap-Weighted Index (cont.)

1. Total market capitalization at the beginning of 2009:

= (30 × 4,000) + (22 × 6,000) + (35 × 2,000) + (50 × 2,500) + (48 × 3,000)
= 591,000
Weights for each of the five securities are:
Security A = (30 × 4,000)/591,000 = 20.30%
Security B = (22 × 6,000)/591,000 = 22.34%
Security C = (35 × 2,000)/591,000 = 11.84%
Security D = (50 × 2,500)/591,000 = 21.15%
Security E = (48 × 3,000)/591,000 = 24.37%

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Example: Market Cap-Weighted Index (cont.)

2. Value of the divisor = 591,000/1,000 = 591

3. Total market capitalization at the end of 2009:
= (34 × 4,000) + (28 × 6,000) + (31 × 2,000) + (54 × 2,500) + (44 × 3,000)
= 633,000
Price return of the index for 2009
= (633,000/591)/1,000 – 1 = 7.11%

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Float-Adjusted Market Capitalization Index

Float-adjusted market-capitalization-weighted index – Market price and number

of shares available to the public determine the constituent weight.
The float‐adjusted market‐capitalization weight of each constituent security is
calculated like that for a regular market capitalization-weighted index:

The difference is that Q in the equation may exclude:

• Closely-held shares
• Shares held by corporations and governments
• Shares not available to foreigners

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Practice Question

A market‐capitalization-weighted equity index consists of three securities

whose year-end prices and number of shares outstanding are given below:

The total return on the index is closest to:

A. –12.50%.
B. –10.42%.
C. 11.63%.

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Practice Question

A market‐capitalization-weighted equity index consists of three securities

whose year-end prices and number of shares outstanding are given below:

The total return on the index is closest to:

A. –12.50%. Answer: B
B. –10.42%. Total Market Cap 2014 = 4,000 + 15,000 + 5,000 = 24,000
C. 11.63%. Total Market Cap 2015 = 6,000 + 7,500 + 8,000 = 21,500
Return = [21,500/24,000] – 1 = –10.42%
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Fundamental-Weighted Index

Fundamental-weighted index – Weights constituent securities based on size of

a fundamental component (e.g., book value, cash flow, revenues, earnings,
dividend yield, or a composite).

Stocks with a higher earnings yield than that of the overall market-weighted
portfolio will be more heavily weighted under fundamental weighting compared
to market-value weighting.

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Rebalancing

Rebalancing - Adjusting weights for the constituent securities in an index to

ensure consistency with the index weighting method.
• Rebalancing an equal-weighted index would require reducing the weight of
securities that have outperformed and increasing the weight of securities
that have underperformed.
• Price-weighted indexes do not need to be rebalanced, as the weight of each
constituent security is determined by its price.
• Market-capitalization-weighted indexes rebalance themselves to reflect
changes in the market capitalization of constituent securities.

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Reconstitution

Reconstitution – Replacing securities that no longer meet the criteria for

inclusion with securities that meet the criteria for inclusion
• Index reconstitution is performed to reflect:
• Changes in the target market due to bankruptcies, de-listings, mergers
• Judgment of the selection committee
• Reconstitution creates turnover within the index (especially for market-value-
weighted indexes), as once the revised list of constituent securities is
determined, the weights of all constituent securities must be recalculated
• Institutional selling (buying) of constituents leaving (entering) the index often
results in price depreciation (appreciation) leading up to the reconstitution

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Uses of Market Indexes

Measuring/Modeling
Asset Classes
Proxies for measuring and
modeling returns, systematic Proxies for asset classes
risk, and risk-adjusted in asset allocation
performance MARKET models
TOP

BULL BEAR
MARKET MARKET

MARKET
BOTTOM
Portfolio Management Sentiment
Benchmarks for passive Indicators of collective
and actively-managed market opinion, attitudes,
portfolios and behaviors

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Practice Question

Uses of market indexes are least likely to serve as a:

A. measure of systemic risk.
B. basis for new investment products.
C. benchmark for evaluating portfolio manager performance.

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Practice Question

Uses of market indexes are least likely to serve as a:

A. measure of systemic risk.
B. basis for new investment products.
C. benchmark for evaluating portfolio manager performance.
Answer: A
A is correct. Security market indexes are used as proxies for measuring market or
systematic risk, not as measures of systemic risk.

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Types of Equity Indexes

BROAD MULTI-
MARKET MARKET SECTOR STYLE
Contains Indexes Includes securities securities
securities comprised of representing a classified
representing more many similar or particular according to style
than 90% of the different types of economic sector. classifications.
market. market.

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Morningstar Size and Style Matrix

Market
Value Blend Growth Capitalization
Absolute market capitalization (e.g., below
Large

€100 million) or relative market capitalization

(e.g., the smallest 2,500 stocks).
Value/Growth
Classification
Mid

Factors and valuation ratios (low price-to-book

ratios, low price-to-earnings ratios, high
dividend yields, etc.) to distinguish between
value and growth equities.
Small

Combinations
Six basic styles with nine possible
combinations.

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Fixed Income Indexes

Creating bond market indexes presents the following challenges:

• There is a broader universe of bonds than of stocks.
• The universe of bonds is constantly changing due to new issues, calls, and
maturities.
• The price volatility of a bond (as measured by duration) is constantly changing.
• Current and continuous transaction prices are not readily available for bonds.

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Fixed Income Index Dimensions

Global

Market Region

Country / Currency

Government
Type Corporate Collateralized Government
agency
For example, 1–3, 3–5, 5–7, 7–10, 10+ years; short-term, medium-
Maturity
term, or long-term
For example, AAA, AA, A, BBB, etc.; Aaa, Aa, A, Baa, etc.;
Credit
investment grade, high yield

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Practice Question

Fixed-income indexes are least likely constructed based on:

A. maturity.
B. type of issuer.
C. coupon frequency.

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Practice Question

Fixed-income indexes are least likely constructed based on:

A. maturity.
B. type of issuer.
C. coupon frequency.
Answer: C
Indexes are seldom if ever based on coupon frequency.

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Commodity Indexes

Commodity indexes – Consist of futures contracts on one or more

commodities.
• They do not have an obvious weighting method, so index providers create
their own weighting methods.
• Different weighting methods lead to different exposures to specific
commodities, which result in very different risk and return profiles of
commodity indexes.
A commodity index return can be quite different from the return based on
changes in the prices of the underlying commodities. Commodity index returns
reflect the risk-free interest rate, the changes in future prices, and the roll yield.

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Real Estate Indexes

Real estate indexes represent the market for real estate and real estate
securities.
They can be categorized as:
• Appraisal indexes
• Repeat sales indexes
• Real estate investment trust (REIT) indexes

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Real Estate Indexes

Hedge funds – Private investment vehicles that typically use leverage and
both long and short investment strategies.
• Voluntary disclosure - Hedge funds are not required to disclose
performance to any party other than investors.
• If they do decide to disclose performance, hedge funds have a choice
regarding which index or indexes they report their performance to.
• Poorly performing hedge funds may stop reporting their performance to
hedge fund indexes or may cease to exist altogether.
• This leads to survivorship bias and an upward bias in hedge fund
performance as represented by these indexes.

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Practice Question

Hedge fund indexes are unique in that they:

A. are frequently equal weighted.
B. are determined by the constituents of the index.
C. reflect the value of private rather than public investments.

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Practice Question

Hedge fund indexes are unique in that they:

A. are frequently equal weighted.
B. are determined by the constituents of the index.
C. reflect the value of private rather than public investments.
Answer: B
Constituents determine the index rather than index providers determining the
constituents. Hedge funds are not required to report their performance to any
party other than their investors. Therefore, each hedge fund decides to which
database(s) it will report its performance.

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