5.2 Security Market Indexes Flashcards
A security market index
represents a market segment or asset class
constituent securities
the individual securities that make up the security market index
an equity index
a portfolio that is designed to represent the performance of an asset class (e.g., US equities)
price weighting
weights each constituent security based on its price as a share of the sum of all the constituent security prices.
The Dow Jones Industrial Average (DJIA) is one of the oldest and best-known price-weighted indexes.
Equal weighting
another index weighing technique that offers the advantage of simplicity.
Each stock in an equally weighted index has the same proportionate impact on the index’s overall performance
The disadvantages of equal weighting
include the disproportionately large influence of relatively small stocks.
Also, frequent rebalancing is required because any price changes will cause the index to deviate from its initial equal weighting.
market-capitalization weighting (a.k.a. value-weighting)
the weight of each security is its market capitalization divided by the total market capitalization of all constituent securities
Most market capitalization weighting schemes use a float adjustment, which excludes the impact of shares that are not freely exchanged
The advantage of market-capitalization weighting schemes
each constituent’s contribution to index performance is proportionate to its value in the target market
The disadvantage of market-capitalization weighting schemes
it leads to overweighting securities that rise in value and underweighting those that fall in value.
This is akin to a momentum investment strategy.
Fundamental weighting
uses a measure of company size not dependent upon security price to determine weight. It could use items such as book value, cash flow, or revenues
his leads to indices with value tilt (e.g., ratio of book value to market value is greater than average).
This method also tends to have a contrarian bent rather than a momentum approach.
Reconstitution
a process in which the manager reviews and makes changes to the constituent securities
Types of Fixed-Income Indexes
Fixed-income indexes fall into many of the same categories as equities indexes:
Broad market indexes
Sector indexes (e.g., government, corporate)
Style indexes (e.g., high-yield)
Commodity Indexes
consist of futures contracts on commodities such as agriculture, livestock, metals, or energy. Indexes are based on futures contracts rather than the underlying commodity prices.
As such, index values will reflect unrelated factors such as the risk-free rate.
