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Reading 37: Security Market Indexes (Uses of security market index…
Reading 37: Security Market Indexes
security market index
Represents the performance of an asset class, security market, or segment of a market.
a change in index value represent the change in market (or segment) performance.
Index returns
Price return
Uses only the prices of the constituent securities to calculate return
Price Return = \(\frac{Ending.Price}{Beginning.Price}-1\)
Total return
use both the price and the income from index securities in the return calculation.
Total Return = \(\frac{Ending.Value+CF}{Beginning.Value}-1\)
Is calculated from market prices of securities that belong in the index
There are different way to weight the constituent securities' values
Index Rebalance and Reconstitution
Rebalance
Periodically update the weights of constituent securities.
It is most important for equal-weighted indexes
Reconstitution
Periodically adding and deleting securities
It is necessary when securities mature or when they no longer have the required characteristics to be included.
Index construction
Things to considerate
Which securities will be included?
Which weighting method will be used?
When will the index be rebalanced?
When will the index's securities be re-examined?
What market does the index represents?
Weighting method
Price-weight index
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
Equal-weighted index
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)
Market capitalization weighted index
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
Fundamental-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
Comparison of Weighting Schemes
Compared to a market-cap weighted index
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
Uses of security market index
Reflection of market sentiment
Benchmark of portfolio manager performance
Measure of market return
Measure of beta
Model portfolio for index funds
Calculate expected and risk-adjusted returns
Types of indexes
Equity indexes
Broad market equity
Represent the majority of stock in a market
Multi-market equity index
Contains the indexes of several countries
Multi-market market cap weighted
Multi-market with fundamental (GDP) weighting
Sector index
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.
Style index
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
Fixed-income indexes
Can be classified by issuers, collaterals, coupons, maturity, credit risk, and inflation-protection.
Can be delineated as broad market, sector, style, or other specialized indexes
Fixed income universe is much broader than the equity universe, and fixed income indexes have higher turnover.
Construction issues
Broad universe, high turnover
Lack of price data
Illiquidity
Alternative investment Indices
represent markets for alternative assets (commodities, real estate, hedge funds, etc.)
Issues
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
Examples
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
Security market indexes can be classified by
Geographic location
Sector or industry
Level of economic development
Fundamental factors
Some examples of Security Market Indexes
Dow Jones Industrial Average
Reflects large U.S stocks
Includes 30 securities, chosen by WSJ editors
Weighting method: Price
Nikkei Stock Average
Reflects large Japanese stocks
Includes 225 securities
Weighting method: Modified price, adjusted for high-priced shares
TOPIX
Reflects all stocks on Tokyo Stock Exchange First Section
Variable number of constituents
Weighting method: market capitalization, adjusted for float
MSCI All Country World Index
Reflect stocks in 23 developed and 24 emerging market
Variable number of constituents
Weighting method: Market-capitalization, adjusted for float
Available in USD and local currency