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Reading 37: Security Market Indexes (Uses of security market index…

- - - - Uses only the prices of the constituent securities to calculate return
      - Price Return = \(\frac{Ending.Price}{Beginning.Price}-1\)
    - - use both the price and the income from index securities in the return calculation.
      - Total Return = \(\frac{Ending.Value+CF}{Beginning.Value}-1\)
- - - - is the arithmetic mean of the prices of the index securities
      - the denominator (number of securities in the index) must be adjusted for stock split )
        
        If the change in price is only due to the stock split, the denominator will be the value that equalizes index before and after the split
        
        Example:
        Stock A=10, B=20, C= 90. Beginning index value = (10+20+90)/3=40
        Stock C splits 2-for-1 -> New price C=45. Current index value still = 40 -> New denominator = 1.875
      - Formula: Price-weight index=\( \frac{Stock Prices}{No. Stock}\)
      - Example: Dow Jones Industrial Average
      - Match by buying an equal number of shares of each stock in the index
      - Given percentage price change in high-priced stock affects the index more than it does for low-priced stock
    - - Assigns the same weight to each of its constituent securities.
      - Calculation
        
        Find the HPR for each constituent stock
        
        Calculate the Arithmetic mean of all HPR
        
        Current index value = Average HPR x Initial index value
      - Match with portfolio of equal dollar investment in each index stock
      - Index return is the average HPR on index stocks
      - Quarterly rebalancing (selling the one that is appreciated, and buying more stocks dropping in price)
    - - give each constituent security a weight equal to its proportion of the total market of all securities in the index
      - Can be adjusted for a security's market float or free float to reflect the fact that not all outstanding shares are available for purchase.
        
        Market float-weighted index with number of shares equal to investable shares (excludes share of controlling investors and often those held by government or corporations)
        
        Free float index when shares not available to foreign investors are excluded
      - Formula: \(\frac{\sum(Price_i \times No.share) }{\sum(Price_0 \times No.share)} \times Index Value_0\)
      - Ex: S&P500
      - Firms with larger market cap influence the index more than firms with smaller market caps
      - Momentum tilt: As stock becomes more expensive, its price-change has more influence on the index
        Thus, overpriced stock have higher weights in value-weighted index
    - - Proportions of index (weights) are based on proportion to total value of a fundamental factor (e.g., revenue, earnings, book value, cash flow)
      - Lead to a value tilt: e.g., high book-to-market have higher weights compared to value-weighted.
      - GDP weights are used in multi-market indexes
    - - Price-weighted index places more weights on high-price stocks, stock splits change all weights (and divisor)
      - Equal-weighted index places more weight on small-cap stocks and less on large-cap stocks, must be rebalanced
      - Float-adjusted index more closely matches investable shares proportion
      - Fundamental-weighted index has a value tilt
- - - - Represent the majority of stock in a market
    - - Contains the indexes of several countries
      - Multi-market market cap weighted
      - Multi-market with fundamental (GDP) weighting
    - - Measure the return for a sector
      - is used to evaluate portfolio managers and as models for investment funds.
      - Example: Health care, technology, finance, consumer goods, etc.
    - - Measure the return to market capitalization on a certain growth strategies.
      - As stocks tend to migrate among classifications, style index tends to have higher constituent turnover than broad market index.
      - Example: Large-cap, mid-cap, small-cap, value vs. growth
  - - - Broad universe, high turnover
      - Lack of price data
      - Illiquidity
  - - - Weighting methods
        different indices can have vastly different commodity weights and resulting risk and return.
      - Commodity index is based on future contract, not the actual commodities
        Which can result in different performance vs. actual commodity
    - - Real estate index
        
        Repeat property sales index
        
        Index of real estate investment trusts
        
        Appraisal index
      - Commodity indexes
        
        Indexes of future contracts; performance may differ from commodity
        
        Wide variety of commodity weights
      - Hedge fund indexes
        
        Self-selection and survivorship bias increase returns