Equities: Security Market Indices

Question 1

Price and Return Indexes =

Answer 1

price indexes will be measured by change in price of the underlying securities

a return index will incorporate both price and payment (coupon) return - TRR, total rate of return value

Question 2

Price weighted index =

Answer 2

arithmetic average of the prices of the securities

will be affected by stock splits etc as these change the denominator of the average

returns would be matched by a portfolio of the same number of each stock in the index

Adv: simple

Dis: higher priced stocks are weighted more heavily.

example is the DJIA

Question 3

Equal weighted index =

Answer 3

arithmetic average return of index stocks, would be matched by a portfolio with equal amounts invested in all index stocks

*take the average of the returns (you’ll have a % return for each stock - average these)*

adv: simplicity
dis: a matching portfolio requires constant rebalancing to keep dollar value invested in each stock equal

returns of small cap securities are overweighted, while returns on big cap securities are underweighted

Question 4

Market cap/value weighted index =

Answer 4

can also use a float or free float weighting

just different metrics for weighting different securities in the index

disadvantages include that higher price leads to greater market cap and greater weighting, a potential issue if a stock is simply overvalued.

Question 5

Fundamental weighted index =

Answer 5

based on fundamentals - ie earnings, dividends etc

adv: avoids bias to overvalued shares that occurs from market weighting
dis: will acually have a ‘value’ tilt to firms with high value based metrics

Question 6

Rebalancing & reconstitution =

Answer 6

rebalancing is most relevant for equal weighted indexes

reconstitution happens when securities are removed and added to meet index criteria

note: when a security is added to the index it often rises in price as managers trying to track the index add it to their portfolios

Question 7

Uses of market indices x5 =

Answer 7

• reflection of market sentiment
• benchmark of manager performance
• measure of market return and risk
• measure of beta and risk adjusted return
• model portfolio for index funds

Question 8

Types of equity indexes =

Answer 8

• Broad market index
• Multi-market index - ie latin america, the world
• Multi-market index with fundamental weighting (country indexes are weighted based on fundamentals, ie GDP, while the constituents in each index are still market cap weighted)
• Sector Index (for portfolio indexes/benchmarks)
• Style Index - ie measures return for a value strategy (will typically have higher turnover)

Question 9

Fixed Income Indexes =

Answer 9

• large universe: the FI universe is larger than the universe of stocks.
• turnover: as FI matures, there is more turnover
• dealer market/infrequent trading: indexes must rely on dealers for pricing, and sometimes estimate

Question 10

Alts Indexes =

Answer 10

Commodity Indexes (via futures)

• weighting method: varies across indexes
• futures, not spot: thus prices incorporate risk free rate, changes in future prices and roll yield.

Real Estate Indexes

Hedge Fund Indexes

Question 11

the index Matrix - should I know this?