Lecture 15: Indexes 3

Indexes and Index Funds Summary

Fundamental Weighted Index Rationale

  • Market-value weighting can distort true performance by over- or under-representing stocks, particularly in cases like the tech boom (1998-2000).

  • Fundamental measures for weighting include sales, profits (cash flow), net assets (book value), and distributions to shareholders (dividends).

  • Market Value reflects trading activities; Fundamental Measures provide a steadier perspective based on financial health.

Style Indexes

  • Categorized by market capitalization and growth/value dimensions:

    • Small-cap Growth, Mid-cap Growth, Large-cap Growth.

    • Small-cap stocks generally outperform large-cap stocks.

    • Value stocks often provide higher risk-adjusted returns compared to growth stocks.

    • Social Responsibility Investing (SRI) indexes are gaining popularity due to rising sustainable investing.

Global Equity Indexes

  • Notable examples include:

    • FTSE Global Equity Index Series covers ~7,700 equities across 47 countries.

    • MSCI Indexes reflect stocks in developed and emerging markets.

Bond Market Basics

  • Bond indices face challenges in construction due to variations in bond types and quality.

  • Types of bond indexes include Aggregate, Investment-grade, High-yield, Agency, Tax-exempt, and Foreign Government Bonds.

Custom Benchmark Creation

  • Investors may create composite indices to track diverse asset classes like real estate and global equities.

Correlation Between Indices

  • Indices can be highly correlated, which affects diversification. Stocks have higher correlation than bonds, but the correlation between stocks and bonds is lower (around 25%).

Investing in Security Market Indexes

  • Indices are used as benchmarks and for creating index funds/ETFs, with passive management growing in popularity.

Differences Between Index Funds and ETFs

  • Index Funds: Replicate index composition with fewer trading costs; limited trading options.

  • ETFs: Allow real-time trading, short selling, and advantageous tax considerations.

Advantages and Disadvantages

  • Index Mutual Funds: Offer cost-effective diversification; potential tax drawbacks.

  • ETFs: Flexible trading and lower tax exposure due to structure.