Reading 37 – Security Market
Indexes
A - Describe a security market index
• A security market index represents a given security market, market segment, or
asset class. Most indexes are constructed as portfolios of marketable securities
• The value of an index is calculated on a regular basis using either the actual or
estimated market prices of the individual securities, known as constituent securities,
within the index. For each security market index, investors may encounter two
versions of the same index
b: Calculate and interpret the value, price return, and total return of an index.
• An index return may be calculated using a price index or a return index. A price
index uses only the prices of the constituent securities in the return calculation. A
rate of return that is calculated based on a price index is referred to as a price return
• A return index includes both prices and income from the constituent securities. A
rate of return that is calculated based on a return index is called a total return. If the
assets in an index produce interim cash flows such as dividends or interest payments,
the total return will be greater than the price return
• An index return may be calculated using a price index or a return index. A price
index uses only the prices of the constituent securities in the return calculation. A
rate of return that is calculated based on a price index is referred to as a price return
• A return index includes both prices and income from the constituent securities. A
rate of return that is calculated based on a return index is called a total return. If the
assets in an index produce interim cash flows such as dividends or interest payments,
the total return will be greater than the price return
C - Describe the choices and issues in index construction and management.
• Constructing and managing a security market index is similar to constructing and
managing a portfolio of securities. Index providers must decide the following:
1 Which target market should the index represent?
2 Which securities should be selected from that target market?
3 How much weight should be allocated to each security in the index?
4 When should the index be rebalanced?
5 When should the security selection and weighting decision be re-examined?
• The target market may be defined very broadly (e.g., stocks in the United States) or
narrowly (e.g., small-cap value stocks in the United States). It may also be defined by
geographic region or by economic sector (e.g., cyclical stocks). The constituent stocks
in the index could be all the stocks in that market or just a representative sample
• The selection process may be determined by an objective rule or subjectively by a
committee
D - Compare the different weighting methods used in index construction
E: Calculate and analyze the value and return of an index given its weighting method.
• The weighting decision determines how much of each security to include in the index
and has a substantial impact on an index’s value. Index providers use a number of
methods to weight the constituent securities in an index
• Indexes can be price weighted, equal weighted, market-capitalization weighted, or
fundamentally weighted. Each weighting method has its advantages and disadvantages
Price Weighting Index
• The simplest method to weight an index and the one used by Charles Dow to construct
the Dow Jones Industrial Average is price weighting
• In price weighting, the weight on each constituent security is determined by dividing
its price by the sum of all the prices of the constituent securities. The weight is
calculated using the following formula
• The advantage of a price-weighted index is that its computation is simple
• One disadvantage is that a given percentage change in the price of a higher priced
stock has a greater impact on the index’s value than does an equal percentage
change in the price of a lower priced stock. Put another way, higher priced stocks have
more weight in the calculation of a price-weighted index
• Additionally, a stock’s weight in the index going forward changes if the firm splits its
stock, repurchases stock, or issues stock dividends, as all of these actions will
affect the price of the stock and therefore its weight in the index
• A portfolio that has an equal number of shares in each of the constituent stocks will
have price returns (ignoring dividends) that will match the returns of a price-weighted
index
• Two major price-weighted indexes are the Dow Jones Industrial Average (DJIA) and the
Nikkei Dow Jones Stock Average
• The DJIA is a price-weighted index based on 30 U.S. stocks. The Nikkei Dow is
constructed from the prices of 225 stocks that trade in the first section of the Tokyo
Stock Exchange
Equal Weighting Index
• Another simple index weighting method is equal weighting. This method assigns an
equal weight to each constituent security at inception. The weights are calculated as:
• One complication with an equal-weighted index return is that a matching portfolio
would have to be adjusted periodically (rebalanced) as prices change so that the
values of all security positions are made equal each period. The portfolio
rebalancing required to match the performance of an equal-weighted index creates
high transactions costs that would decrease portfolio returns
• Another concern with an equal-weighted index is that the weights placed on the
returns of the securities of smaller capitalization firms are greater than their
proportions of the overall market value of the index stock
Market Capitalization Weighting Index
• In market-capitalization weighting, or value weighting, the weight on each constituent
security is determined by dividing its market capitalization by the total market
capitalization (the sum of the market capitalization) of all the securities in the index
• Market capitalization or value is calculated by multiplying the number of
shares outstanding by the market price per share.
• An alternative to using a firm’s market capitalization to calculate its weight in an
index is to use its market float
• A firm’s market float is the total value of the shares that are actually available to the
investing public and excludes the value of shares held by controlling stockholders
because they are unlikely to sell their shares
• For example, the float for Microsoft would exclude shares owned by Bill Gates and
Paul Allen (the founders) and those of certain other large shareholders as well
• The market float is often calculated excluding those shares held by corporations or
governments as well. Sometimes the market float calculation excludes shares that
are not available to foreign buyers and is then referred to as the free float
• The reason for this is to better match the index weights of stocks to their proportions
of the total value of all the shares of index stocks that are actually available to investors
• A float-adjusted market capitalization-weighted index is constructed like a market
capitalization-weighted index. The weights, however, are based on the
proportionate value of each firm’s shares that are available to investors to the total
market value of the shares of index stocks that are available to investors
• Fundamental weighting attempts to address the disadvantages of market-
capitalization weighting by using measures of a company’s size that are independent of
its security price to determine the weight on each constituent security
• These measures include book value, cash flow, revenues, earnings, dividends, and
number of employees. Some fundamental indexes use a single measure, such as
total dividends, to weight the constituent securities, whereas others combine the
weights from several measures to form a composite value that is used for weighting.
• An advantage of a fundamental-weighted index is that it avoids the bias of market
capitalization-weighted indexes toward the performance of the shares of
overvalued firms and away from the performance of the shares of undervalued firms
• A fundamental-weighted index will actually have a value tilt, overweighting firms
with high value-based metrics such as book-to-market ratios or earnings yields
• Note that a firm with a high earnings yield (total earnings to total market value) relative
to other index firms will by construction have a higher weight in an earnings-weighted
index because, among index stocks, its earnings are high relative to its market value
Exercise
1. The values of a price return index and a total return index consisting of identical equal-weighted dividend-paying equities will be equal:
A only at inception.
B at inception and on rebalancing dates.
C at inception and on reconstitution dates.
2. An analyst gathers the following information for an equal-weighted index comprised of assets Able, Baker, and Charlie:
The price return of the index is:
A 1.7%.
B 5.0%.
C 11.4%.
3. An analyst gathers the following information for a price-weighted index comprised of securities ABC, DEF, and GHI:
The price return of the index is:
A –4.6%.
B –9.3%.
C –13.9%.
4. An analyst gathers the following information for a market-capitalization-weighted index comprised of securities MNO, QRS, and XYZ:
The total return of the index is:
A 1.04%.
B –5.35%.
C –10.23%.
5. Which of the following index weighting methods requires an adjustment to the divisor after a stock split?
A Price weighting.
B Fundamental weighting.
C Market-capitalization weighting.
6. If the price return of an equal-weighted index exceeds that of a market-capitalization-weighted index comprised of the same
securities, the most likely explanation is:
A stock splits.
B dividend distributions.
C outperformance of small-market-capitalization stocks.
7. Which of the following index weighting methods requires the most frequent rebalancing?
A Price weighting.
B Equal weighting.
C Market-capitalization weighting.
F - Describe rebalancing and reconstitution of an index
• Rebalancing refers to adjusting the weights of securities in a portfolio to their
target weights after price changes have affected the weights
• For index calculations, rebalancing to target weights on the index securities is done
on a periodic basis, usually quarterly
• Because the weights in price- and value-weighted indexes (portfolios) are adjusted
to their correct values by changes in prices, rebalancing is an issue primarily for
equal-weighted indexes
• As noted previously, the weights on security returns in an (initially) equal-weighted
portfolio are not equal as securities prices change over time. Therefore, rebalancing
the portfolio at the end of each period used to calculate index returns is necessary for
the portfolio return to match the index return
• Index reconstitution refers to periodically adding and deleting securities that make
up an index. Securities are deleted if they no longer meet the index criteria and are
replaced by other securities that do. Indexes are reconstituted to reflect corporate
events such as bankruptcy or delisting of index firms and are at the subjective
judgment of a committee
G - Describe uses of security market indexes
Security market indexes have several uses:
1. Reflection of market sentiment. Indexes provide a representative market return
and thus reflect investor confidence
Although the Dow Jones Industrial Average is a popular index, it reflects the
performance of only 30 stocks and thus may not be a good measure of sentiment
with regard to the broader market
2. Benchmark of manager performance. An index can be used to evaluate the
performance of an active manager. Because portfolio performance depends to a
large degree on its chosen style, the benchmark should be consistent with the
manager’s investment approach and style to assess the manager’s skill accurately
The index stocks should be those that the manager will actually choose from. For
example, a value manager should be compared against a value index, not a broad
market index, because portfolio securities will be selected from among value stocks
3. Measure of market return and risk. In asset allocation, estimates of the
expected return and standard deviation of returns for various asset classes are
based on historical returns for an index of securities representing that asset class
4. Measure of beta and risk-adjusted return. The use of the capital asset pricing
model
(CAPM) to determine a stock’s expected return requires an estimate of its beta and
the return on the market
• Index portfolio returns are used as a proxy for the returns on the market portfolio,
both in estimating a stock’s beta, and then again in calculating its expected return
based on its systematic (beta) risk
• Expected returns can then be compared to actual stock returns to determine
systematic risk-adjusted returns
5. Model portfolio for index funds. Investors who wish to invest passively can
invest in an index fund, which seeks to replicate the performance of a market
index
• There are index mutual funds and index exchange-traded funds, as well as private
portfolios that are structured to match the return of an index
H - Describe types of equity indexes
Investors can use a variety of equity market indexes. These equity indexes can
be classified as follows:
1. Broad market index. Provides a measure of a market’s overall performance and
usually contains more than 90% of the market’s total value. For example, the
Wilshire 5000 Index contains more than 6,000 equity securities and is, therefore, a
good representation of the overall performance of the U.S. equity market
2. Multi-market index. Typically constructed from the indexes of markets in several
countries and is used to measure the equity returns of a geographic region (e.g.,
Latin America indexes), markets based on their stage of economic development (e.g.,
emerging markets indexes), or the entire world (e.g., MSCI World Index)
Multi-market index with fundamental weighting. Uses market capitalizationweighting
for the country indexes but then weights the country index returns in the global index by
a fundamental factor (e.g., GDP). This prevents a country with previously high stock
returns from being overweighted in a multi-market index.
3. Sector index. Measures the returns for an industry sector such as health care,
financial, or consumer goods firms. Investors can use these indexes in cyclical analysis
because some sectors do better than others in various phases of the business cycle.
Sector indexes can be for a particular country or global. These indexes are used to
evaluate portfolio managers and to construct index portfolios
4. Style index. Measures the returns to market capitalization and value or growth
strategies. Some indexes reflect a combination of the two (e.g., small-cap value fund).
Because there is no widely accepted definition of large-cap, midcap, or small-cap
stocks, different indexes use different definitions
• These definitions may be specified values of market capitalization or relative
definitions, such as defining large-cap stocks as the largest 500 firms in a given
market. In constructing value stock and growth stock indexes, price-to earnings ratios
or dividend yields are often used to identify value and growth stocks
• Over time, stocks can migrate from one classification to another. For example, a
successful small-cap company might grow to become a mid-cap or large-cap
company. This causes style indexes to typically have higher turnover of constituent
firms than broad market indexes
I - Describe types of fixed-income indexes
Fixed income securities vary widely with respect to their coupon rates, ratings,
maturities, and embedded options such as convertibility to common stock.
Consequently, a wide variety of fixed income indexes is available. Like equity indexes,
fixed income indexes are created for various sectors, geographic regions, and levels of
country economic development. They can also be constructed based on type of issuer
or collateral, coupon, maturity, default risk, or inflation protection. Broad market
indexes, sector indexes, style indexes, and other specialized indexes are available
Investors should be aware of several issues with the construction of fixed
income indexes:
1. Large universe of securities. The fixed income security universe is much broader than
the universe of stocks. Fixed income securities are issued not just by firms, but also
by governments and government agencies. Each of these entities may also issue
various types of fixed income securities. Also, unlike stocks, bonds mature and must be
replaced in fixed income indexes. As a result, turnover is high in fixed income indexes.
2. Dealer markets and infrequent trading. Fixed income securities are primarily traded
by dealers, so index providers must depend on dealers for recent prices. Because
fixed income securities are typically illiquid, a lack of recent trades may require index
providers to estimate the value of index securities from recent prices of securities with
similar characteristics
J - Describe indexes representing alternative investments
Alternative assets are of interest to investors because of their potential diversification
benefits. Three of the most widely held alternative assets are commodities, real
estate, and hedge funds
1. Commodity indexes represent futures contracts on commodities such as grains,
livestock, metals, and energy. Examples include the Commodity Research Bureau
Index and the S&P GSCI (previously the Goldman Sachs Commodity Index)
The issues in commodity indexes relevant for investors are as follows:
Weighting method. Commodity index providers use a variety of weighting
schemes. Some use equal weighting, others weight commodities by their global
production values
As a result, different indexes have significantly different commodity exposures and risk
and return characteristics. For example, one index may have a large exposure to the
prices of energy commodities while another has a large exposure to the prices of
agricultural products
• Futures vs. actual. Commodity indexes are based on the prices of commodity
futures contracts, not the spot prices of commodities
• Commodity futures contracts reflect the risk-free rate of return, changes in futures
prices, and the roll yield
• Furthermore, the contracts mature and must be replaced over time by other
contracts. For these reasons, the return on commodity futures differs from the
returns on a long position in the commodity itself
2. Real estate indexes can be constructed using returns based on appraisals of
properties, repeat property sales, or the performance of Real Estate Investment
Trusts (REITs)
• REITs are similar to closed-end mutual funds in that they invest in properties or
mortgages and then issue ownership interests in the pool of assets to investors
• While real properties are quite illiquid, REIT shares trade like any common shares and
many offer very good liquidity to investors. FTSE International produces a family of
REIT indexes.
3. Most hedge fund indexes equally weight the returns of the hedge funds included in
the index. Hedge funds are largely unregulated and are not required to report their
performance to index providers
• Consequently, some funds will report to one index but not another. The performance
of different indexes can thus vary substantially
• Furthermore, it is often the case that those funds that report are the funds that have
been successful, as the poorly performing funds do not want to publicize their
performance
• Funds that have reported in the past but have recently had poor returns may stop
reporting their performance. The result is an upward bias in index returns, with
hedge funds appearing to be better investments than they actually are
Exercise
1. Rebalancing an index is the process of periodically adjusting the constituent:
A securities’ weights to optimize investment performance.
B securities to maintain consistency with the target market.
C securities’ weights to maintain consistency with the index’s weighting method.
2. Reconstitution of a security market index reduces:
A portfolio turnover.
B the need for rebalancing.
C the likelihood that the index includes securities that are not representative of the target market.
3. Security market indexes are used as:
A measures of investment returns.
B proxies to measure unsystematic risk.
C proxies for specific asset classes in asset allocation models.
4. Uses of market indexes do not include serving as a:
A measure of systemic risk.
B basis for new investment products.
C benchmark for evaluating portfolio performance.
5. Which of the following is an example of a style index? An index based on:
A geography.
B economic sector.
C market capitalization.
