Reading 40: Security Market Indexes

Book 2: Equity Investments

Security Market Index

represents the performance of an asset class, security market, or segment of a market

Constituent Securities

the securities that in aggregate makes the index

What are the two ways an index return can be calculated?

Price Index

Return Index

Price Index

uses only the prices of the constituents in the calculation

called Price Return

Return Index

includes both prices and income from constituents

called Total Return

Price-Weighted Index

the arithmetic average of the prices of the securities in the index

• higher weights to higher prices, regardless of size

• lower weights to lower prices, regardless of size

Advantage of Price-Weighted Index

computation is simple

Disadvantage of Price-Weighted Index

a gain in a higher price has a greater impact on the index’s value than the same gain of a lower price stock

Examples of Price-Weighted Indexes

DIJA, Nikkei

Equal-Weighted Index

invests the same dollar amount in each stock

Advantage of Equal-Weighted Indexes

computation is simple

Disadvantage of Equal-Weighted Indexes

constant rebalancing creates high transaction fees

Examples of Equal-Weight Indexes

Value Line Composite Average, Financial Times Ordinary Share Index

Market Cap-Weighted Index

weights based on the market cap of each index stock

Which index doesn’t have to be adjusted for splits or dividends?

Market Cap-Weighted

Market Float

the total value of the shares that are available to the public

usually excludes shares held by controlling stockholders, governments, and corporations

Free Float

Market Float - shares foreign investors can’t buy

Float-Adjusted Market Cap-Weighted Index

assigns weights to each stock based on the market float, relative to the total float-adjusted market value of all stocks in the index

Advantage of Float-Adjusted Market Cap-Weighted Index

index weights are actual proportions of total market value

Disadvantage of Float-Adjusted Market Cap-Weighted Index

impact of a stock’s return in the index increases as its price rises and decreases as it falls

• Potential overvalued stocks will be given a large weight

• Potentially undervalued stocks will be given a small weight

Example of an Float-Adjusted Mark Cap-Weighted Index

S&P 500

Fundamental-Weighted Index

weights are based on firm fundamentals

Rebalancing

adjusting the weights of securities to their target weights after prices have changed

How often are indexes rebalanced (usually)?

quarterly

Reconstitution

periodically adding and deleting securities from an index

Broad-Market Index

measure of a market’s overall performance

Multi-Market Index

constructed from the indexes of other markets from several countries

• geographic regions

• markets in the same economic development phase

• entire world

Multi-Market Index with Fundamental Weighting

use market cap-weighting for the index but then weights the country index returns in global index by a fundamental factor

Style Index

measures the returns to market cap and value or growth strategies

Issues with fixed-income indexes?

infrequent trading and constant reconstitution

What is in a commodity index?

future contracts

What type of weighting do hedge fund indexes use?

equal weighting