(46) Security Market Indices

Question 1

LOS 46. a: Describe a security market index.

Answer 1

A security market index represents the performance of an asset class, security market, or segment of a market. The performance of the market or segment over a period of time is represented by the percentage change in (i.e., the return on) the value of the index.

Question 2

LOS 46. b: Calculate and interpret the value, price return, and total return of an index. Define price index and price return.

Answer 2

A price index uses only the prices of the constituent securities in the return calculation. The rate of return is called a price return.

Question 3

LOS 46. b: Calculate and interpret the value, price return, and total return of an index. Define total return index.

Answer 3

A total return index uses both the price of and the income from the index securities in the return calculation.

Question 4

LOS 46. c: Describe the choices and issues in index construction and management.

Answer 4

Decisions that index providers must make when constructing and managing indexes include:

• The target market the index will measure.
• Which securities from the target market to include.
• The appropriate weighting method.
• How frequently to rebalance the index to its target weights.
• How frequently to re-examine the selection and weighting of securities.

Question 5

LOS 46. d: Compare the different weighting methods used in index construction. Define a price-weighted index.

Answer 5

A price-weighted index is the arithmetic mean of the prices of the index securities. The divisor, which is initially equal to the number of securities in the index, must be adjusted for stock splits and changes in the composition of the index over time.

Question 6

LOS 46. d: Compare the different weighting methods used in index construction. Define a equal-weighted index.

Answer 6

An equal-weighted index assigns the same weight to each of its constituent securities.

Question 7

LOS 46. d: Compare the different weighting methods used in index construction. Define a market capitalization-weighted index.

Answer 7

A market capitalization-weighted index gives each constituent security a weight equal to its proportion of the total market value of all securities in the index. Market capitalization can be adjusted for a security’s market float or free float to reflect the fact that no all outstanding shares are available for purchase.

Question 8

LOS 46. d: Compare the different weighting methods used in index construction. Define a fundamental-weighted index.

Answer 8

A fundamental-weighted index uses weights that are independent of security prices, such as company earnings, revenue, assets, or cash flow.

Question 9

LOS 46. e: Calculate and analyze the value and return of an index given its weighting method. What is the price-weighted index formula?

Answer 9

Price-weighted index = (sum of stock prices) / Number of stocks in index adjusted for splits

Question 10

LOS 46. e: Calculate and analyze the value and return of an index given its weighting method. What is the market capitalization-weighted index formula?

Answer 10

Market capitalization-weighted index = (current total market value of index stocks / base year total market value of index stocks ) x base year index value

Question 11

LOS 46. e: Calculate and analyze the value and return of an index given its weighting method. What is the equal-weighted index formula?

Answer 11

Equal-weighted index = (1 + average percentage change in index stocks) x initial index value

Question 12

LOS 46. f: Describe rebalancing and reconstitution of an index.

Answer 12

Index providers periodically rebalance the weights of the constituent securities. This is most important for equal-weighted indexes.

Question 13

LOS 46. f: Describe rebalancing and reconstitution of an index.

Answer 13

Reconstitution refers to changing the securities that are included in an index. This is necessary when securities mature or when they no longer have the required characteristics to be included.

Question 14

LOS 46. g: Describe uses of security market indices.

Answer 14

Indexes are used for the following purposes:

• Reflection of market sentiment
• Benchmark of manager performance
• Measure of market return
• Measure of beta and excess return
• Model portfolio for index funds

Question 15

LOS 46. h: Describe types of equity indices. Broad market equity indexes

Answer 15

Board market equity indexes represent the majority of stocks in a market.

Question 16

LOS 46. h: Describe types of equity indices. Multi-market equity indexes

Answer 16

Multi-market equity indexes contain the indexes of several countries. Multi-market equity indexes with fundamental weighting use market capitalization weighting for the securities within a country’s market but then weight the countries within the global index by a fundamental factor.

Question 17

LOS 46: What is the most widely used global security indexes?

Answer 17

Most global security indexes are market capitalization-weighted with a float adjustment to reflect the amount of shares available to investors.

Question 18

LOS 46. h: Describe types of equity indices. Sector indexes

Answer 18

Sector indexes measure the returns for a sector (e.g., health care) and are useful because some sectors do better than others on certain business cycle phases. These indexes are used to evaluate portfolio managers and as models for sector investment funds.

Question 19

LOS 46. h: Describe types of equity indices. Style indexes

Answer 19

Style indexes measure the returns to market capitalization and value or growth strategies. Stocks tend to migrate among classifications, which cause style indexes to have higher constituent turnover than broad market indexes.

Question 20

LOS 46. i: Describe types of fixed-income indices. How can fixed income indexes be classified?

Answer 20

Fixed income indexes can be classified by:

• Issuer
• Collateral
• Coupon
• Maturity
• Credit risk (e.g., investment grade versus high-yield), and;
• Inflation protection.

Question 21

LOS 46. i: Describe types of fixed-income indices. How can fixed-income indices be delineated?

Answer 21

They can be delineated by:

• broad market
• sector
• style, or;
• other specialized indexes.

Question 22

LOS 46. i: Describe types of fixed-income indices. What are areas that fixed-income indexes exist for?

Answer 22

Indexes exist for various:

• sectors
• regions, and;
• levels of development.

Question 23

LOS 46. i: Describe types of fixed-income indices. What are some issues with fixed income indices?

Answer 23

The fixed income security universe is much broader than the equity universe, and fixed income indexes have higher turnover. Index providers must depend on dealers for fixed income security prices, and the securities are often illiquid. Fixed income security indexes vary widely in their numbers of constituent securities and can be difficult and expensive to replicate.

Question 24

LOS 46. j: Describe indices representing alternative investments. What are some alternative asset markets that indexes have been developed for?

Answer 24

Indexes have been developed to represent markets for alternative assets such as commodities, real estate, and hedge funds.

Question 25

LOS 46. j: Describe indices representing alternative investments. What are some issues in creating commodity indexes?

Answer 25

Issues in creating commodity indexes include the weighting method (different indexes can have vastly different commodity weights and resulting risk and return) and the fact that commodity indexes are based on the performance of commodity futures contracts, not the actual commodities, which can result in different performance for a commodity index versus the actual commodity.

Question 26

LOS 46. j: Describe indices representing alternative investments. What are some real estate indexes?

Answer 26

Real estate indexes include:

• appraisal indexes
• repeat property sales indexes, and;
• indexes of real estate investment trusts.

Question 27

LOS 46. j: Describe indices representing alternative investments. What are the problems with hedge fund indexes?

Answer 27

Because hedge funds report their performance to index providers voluntarily, the performance of different hedge fund indexes can vary substantially and index returns have an upward bias.

Question 28

LOS 46. k: Compare types of security market indices.

Answer 28

Security market indexes available from commercial providers represent a variety of asset classes and reflect target markets that can be classified by:

• Geographic location, such as country, regional, or global indexes.
• Sector or industry, such as indexes of energy producers.
• Level of economic development, such as emerging market indexes.
• Fundamental factors, such as indexes of value stocks or growth stocks.