Part 7. Security Market Indexes

Question 1

Security Market Index

Answer 1

This is used to represent the performance of an asset class, security market or segment of a market.

Usually created as portfolios of individual securities referred to as constituent securities of an index.

Question 2

Index

Answer 2

Index - a numerical value calculated from market prices (actual when available or estimated) of its constituent securities at a point in time.

Index return - % change in index’s value over a period of time calculated using price or return index.

Question 3

Price index

Answer 3

This uses only the prices of constituent securities in the return calculation

price return = a rate of return that is calculated based on price index.

Question 4

Return index

Answer 4

This includes both prices and income from constituent securities.

Total return = a rate of return calculated based on return index, if assets in index produce interim cash flows such as dividends or interest payments, total return will be greater than price return.

Question 5

Index providers must make several decisions:

Answer 5

This could be about:

1. target market index intends to measure
2. securities from target market to include
3. whether securities should be weighted in index
4. how often index be rebalanced
5. when should selection and weighting of securities be re-examined

Target market can be defined:

• broadly or narrowly
• by geographic region or economic sector
• all stocks in market or representative sample
• selection process determined by objective rule or subjectively by committee.

Question 6

Different weighting methods used in index construction:

Answer 6

1. Price-weighted index
2. Equal-weighted index
3. Market capitalisation-weighted index (value weighted)
4. Market float market capitalisation-weighted index
5. Float-adjusted market capitalisation-weighted index
6. Fundamental weighting

Question 7

Price-weighted index

Answer 7

An arithmetic average of prices of securities included in the index, with divisor adjusted for stock splits, and changes in composition of index when securities are added or deleted, such that index value is unaffected by such changes.

Question 8

Pros and cons of price-weighted index

Answer 8

Pros:

• The computation is simple.

Cons:

• Given % change in price of higher priced stock has greater impact on index value than equal % change in price of lower priced stock, i.e. higher priced stocks have more weight in calculation of price-weighted index.
• Stock’s weight in index going forward changes if firm splits its stock, repurchases stock or issues stock dividends as all actions affect price of stock, hence weight in the index.
  i. e. portfolio of equal number of shares in each constituent stocks have price returns that will match returns of price-weighted index, such as Dow Jones Industrial Average (DJIA), or Nikkei Dow Jones Stock Average.

Question 9

Equal-weighted index

Answer 9

This is the arithmetic average return of the index stocks, for a given time period, would be matched by returns on portfolio that had equal dollar amounts invested in each index stock.

e.g. The Value Line Composition Average, The Financial Times Ordinary Share Index

Question 10

Pros and cons of equal-weighted index

Answer 10

Pros:

• Its simplicity.

Cons:

• Matching portfolio would have to be adjusted periodically (rebalanced) as prices change so values of all security positions are made equal each period, creating high transaction costs decreasing portfolio returns.
• weights placed on returns of securities of smaller capitalisation firms are greater than their proportions of overall market value of index stocks, and vice versa.

Question 11

Market capitalisation-weighted index (value weighted)

Answer 11

This has weights based on market cap. of each index stock (price x no. of shares outstanding) as proportion of total market capitalisation of all stock in index.

• this can be matched with portfolio in which value of each security position in portfolio is is the same proportion of total portfolio value as securities market cap. to total market cap. of all securities included in index.
• closely represent changes in aggregate investor wealth
• weight of index stock being based on its market cap., the market cap. weighted index not need to be adjusted when stock splits or pays stock dividend.
  e. g. S&P 500

Question 12

Market float market capitalisation-weighted index

Answer 12

The total value of shares actually available to investing public, excluding value of shares held by controlling stockholders as unlikely to sell their shares, corporations and governments.

e.g. float for Microsoft excludes shares owned by Bill Gates

Free float - market float calculation excludes shares not available to foreign buyers, to better match index weights of stocks to their proportions of total value of all shares index stocks actually available to investors.

Question 13

Float-adjusted market capitalisation-weighted index

Answer 13

Constructed like a market cap. weighted index.

• Weights are based on proportionate value of each firms shares available to investors to total market value of shares of index stocks available to investors.
• Firms with relative large % of shares held by controlling stockholders will have less weight than in adjusted market cap. index.

Question 14

Pros and cons of market capitalisation-weighted index (value weighted):

Answer 14

Pros:

• index security weights represent proportions of total market value.

Cons:

• the relative impact of stocks return on index increases as its price rises, and decreases as it price falls, so stocks possibly overvalued are given disproportionately high weights in index, and vice versa.
• portfolio tracking value-weighted index is similar to which most successful stocks are given greatest weights and poo performing stocks are underweighted.

Question 15

Fundamental weighting

Answer 15

This uses weights based on firm fundamentals such as earnings, dividends or cash flow.

• These weights are unaffected by the share prices of index stocks
• Based on a single measure or some combo of fundamental measures.

Question 16

Pros and cons of fundamental weighting

Answer 16

Pros:

• It avoids bias of market cap. indexes toward performance of shares of overvalued firms, and away from performance of shares of undervalued firms.
• Has a value tilt, overweighting firms with high value based metrics such as book-to-market ratios or earnings yield (high earnings yield means higher weight in earnings weighted index as its earnings are high relative to its market value.

Question 17

Price weighted index

Answer 17

This adds the market prices of each stock in the index and divides by the number of stock in index.

The divisor must be adjusted for stock splits and other changes in the index portfolio to maintain continuity of series over time.

Question 18

Market capitalisation-weighted index

Answer 18

This is calculated by summing the total value (current stock price x nom of shares outstanding) of all the stocks in the index.

This sum is then divided by similar sum calculated during the stocks in the index, and the ratio is then multiplied by index’s bas value (typically 100).

Question 19

Rebalancing

Answer 19

• Adjusting the weights of securities in a portfolio to their target weights after price changes have affected the weights.
• for index cal. rebalancing target weights on index securities is done on a periodic basis, usually quarterly, as portfolios are adjusted for correct values by changes in prices, rebalancing is an issue for equal-weighted indexes.
• for equity weighted portfolio, the weights on security returns are not equal as securities prices change over time.
• so, rebalancing portfolio at end of each period used to calculate index returns is necessary for portfolio return to match index return.

Question 20

Reconstitution

Answer 20

This is periodically adding and deleting securities that make up an index, if no longer meet index criteria and replaced by other securities that do.

Indexes are reconstituted to reflect corporate events such as bankruptcy or delisting of index firms, subjective to judgement of committee.

Additions and deletions require weights on returns of other index stocks be adjusted to conform desired weighting scheme, with prices rising from buying security and fall from selling them.

Question 21

uses of security market index

Answer 21

1. reflection of market sentiment
2. benchmark of manager performance
3. measure of market and return risk
4. measure of beta and risk adjusted return
5. model portfolio for index funds - for investors who wish to invest passively, seeking to replicate a market index being index mutual funds and EFTs, and private portfolios.

Question 22

Types of equity indexes

Answer 22

1. Broad market index - provides measure of markets overall performance usually containing more than 90% of markets total value.
2. Multi-market index - constructed to measure equity returns of a geographical region (Latin America indexes), stage of economic development (emerging market index) and entire world (MSCI World Index).
3. Multi-market index with fundamental weighting - uses market cap. weighted index of country by weighted to global index by fundamental factor (e.g. GDP), preventing country with previously high stock returns from being overweighed in multi-market index.
4. Sector index - returns for industry sector such as health care, used in cyclical analysis as some sector perform better in different phases of the business cycle.
5. Style index - measures the returns to market cap. and value or growth strategies, with some indexes reflecting combo of two (e.g. small-cap value fund).
   - There is no widely accepted definition of cap stocks, but value stock, growth stock indexes, price-to-earnings ratios and dividend yields are used to identify value and growth stocks.

Question 23

Types of fixed income securities

Answer 23

Vary widely:

• coupon rates
• ratings
• maturities
• embedded options such as convertibility to common stock

They can be constructed based on:

• sectors
• geographic regions
• levels of country economic development
• type of issuer
• Collateral, coupon, maturity, default risk or inflation protection

Question 24

Types of issues with construction of fixed income indexes:

Answer 24

1. Large universe of securities

• Much broader than universe of stocks
• issued by firms and gov/gov agencies
• each entity may issue various types of FI securities
• bonds mature, and must be replaced in FI indexes
• turnover is high in FI indexes

2. Dealer markets and infrequent trading

• FI securities primarily traded by dealers, so index providers depend on dealers for recent prices.
• FI securities are typically illiquid, lack of recent trades may require index providers to est. value of index securities from recent price of similar securities.
• there are large differences in no. of index securities among fixed income securities who are typically illiquid, transaction costs and high turnover make it difficult and expensive to replicate FI index.

Question 25

Alternative investments

Answer 25

• These are of interest due to diversification benefits potential; with most widely used assets being commodities, real estate, and hedge funds.

Question 26

Commodity index

Answer 26

This represents future contracts on commodities such as grain, livestock, metals and energy.

e.g. Reuters/Core Commodity CRB Index

Question 27

Issues relating to commodity index

Answer 27

1. Weighting method
   - use of a variety of weighting schemes means different indexes have significant different commodity exposures and risk and return characteristics.
   e. g. one index may have large exposure to prices of energy commodities, while another has large exposure to prices of agricultural products.
2. Futures vs actual

• commodity index based on price of commodity futures, not spot, which reflect risk free rate of return, changes in future prices and roll yield.
• contracts mature and must be replaced over time by other contracts, so returns differ from returns on long position in commodity itself.

Question 28

Real estate indexes

Answer 28

This can be constructed using returns based on appraisals of properties, repeat property sales or performance of Real Estate Investment Trusts (REITs).

• similar to close end mutual funds investing in property, mortgages, and issue ownership interests in pool of assets to investors.
• properties are illiquid, but REIT shares trade like common shares, offering very good liquidity to investors.

Question 29

Hedge fund indexes

Answer 29

• Invested in non traditional assets using leverage (borrowed money or derivative contracts), and both long and short positions.
• most equally weight returns of hedge funds included in index.
• largely unregulated and not required to report their performance to index providers, some may report one index but not another; thus substantial performance.
• funds reported have been successful, but poorly performing funds are not publicised; so upward bias in index returns, with hedge funds appearing to be better investments than actually are.