Level I Equity Investments

Security Market Indices

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Contents
1.
2.
3.
4.
5.
6.
7.

Introduction
Index Definition and Calculations of Value and Returns
Index Construction and Management
Uses of Market Indices
Equity Indices
Fixed-Income Indices
Indices for Alternative Investments

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1. Introduction
Index: an indicator, sign, or measure of something
Security market indices were first introduced as a simple measure to reflect the
performance of the U.S. stock market
Now security market indices have multiple uses that help an investor track
performance of various markets, estimate risk and evaluate the performance of an
investment
Major indices include S&P 500, FTSE and Nikkei

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2. Index Definition and Calculations of Value and Return

Security market indices measure the value of different target markets
(security markets, market segments, asset classes)
Index value is calculated on a regular basis using actual or estimated
prices of constituent securities
Price return index versus total return index
Price return index only considers changes in price
Total return considers changes in price and income

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Calculations of Value and Return

Calculation of single period returns is similar to the calculation of holding period
returns

Calculation of index values over multiple periods is done by linking returns

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3. Index Construction and Management

Which target market should the index represent?
Which securities should be selected from that target
market?
How much weight should be allocated to each security
in the index?
When should the index be rebalanced?
When should the security selection and weighted
decision be re-examined?
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Target Market and Security Selection

Identify the target market, market segment, or asset class
Can be defined broadly or narrowly
Can be based on asset class, geographic region, exchange and/or other
characteristics

Target market determines the investment universe

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Index Weighting
Index weighting determines how much of each security to include in the
index. This decision impacts index value. The major index weighting
methods are:

Price Weighting
Equal Weighting
Market-Capitalization Weighting
Fundamental Weighting

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Price Weighting
The weight on each security is determined by dividing its price by the sum of all prices
BOP
Price

BOP
Wgt

EOP
Price

Div/
Share

20%

30%

10

50%

14

Using a divisor of 3, compute 1) index value and 2)

the price return and total return.
If there is a 2-for-1 split in Stock C during the
period, what is impact on the index value and
return calculations?
What are the pros and cons of the price weighting
method?

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Equal Weighted Index

Assign equal weight to each constituent security at inception
BOP
Price

EOP
Price

Div/
Share

10

14

Compute the price return and total return.

How can you create an equal weighted portfolio?
What are the pros and cons of the equal weighting
method?

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Market Capitalization Weighted Index

Weight of each security is determined by dividing its market capitalization with total
market capitalization
# of
BOP
Shares Price

EOP
Price

Div/
Share

500

100

100

10

14

What divisor must be used such that the

initial index value is 1000?
Compute the 1) final index value 2) price
return and total return.
Compute the price return if Stock C has a
market float of 40%.
What are the pros and cons of the market
capitalization weighting method?
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Fundamental Weighting
Fundamental weighting uses measures such as book value, cash flow, revenue,
earnings and dividends to calculate the weight of each security
# of
BOP
Shares Price

Earning EOP
Price

500

20

100

20

100

10

20

14

Compute the price return.

What are the pros and cons of the fundamental
weighting method?
Note the value tilt.

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Summary of Results
# of
Shares

BOP
Price

EOP
Price

Earnings

Div/
Share

500

20

100

20

100

10

14

20

Method

Price Return

Total Return

Price

10.0%

25.0%

Equal

-3.3%

8.9%

Market Cap

-16.6%

8.3%

Fundamental

-3.3%

8.9%
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Pros/Cons of Index Weighting Methods

Method

Pros

Cons

Price

Simple

Arbitrary weights

Equal

Simple

High market cap stock under-represented

Requires frequent rebalancing

Market Cap

Securities held in
proportion to their value

Influenced by overpriced securities

Fundamental

Value tilt

Does not consider market value

Requires rebalancing

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Index Management: Rebalancing and Reconstitution

Rebalancing means adjusting weights of constituent securities
Important for equal-weighted indices

Reconstitution means changing constituent securities

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4. Uses of Market Indices

Indicator of how a given market is performing (measure of return)
Gauge market sentiment
Proxies for measuring and modeling returns, systematic risk and risk adjusted
performance
Proxies for asset classes in asset allocation models
Benchmarks for actively modeled portfolios
Model portfolios for index funds and ETFs

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5. Equity Indices
Broad Market Indices
Multi-Market Indices
Sector Indices
Help determine whether active investment manager is
more successful at stock selection or sector allocation
Style Indices
Market Capitalization
Value/Growth
Market Capitalization and Value/Growth
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6. Fixed-Income Indices
Fixed income indices are challenging to construct
Large number and variety of fixed income securities; pricing data not always available
Many fixed income securities are not liquid; not easy to replicate
U.S. Aggregate Bond Index represents the broad market of U.S. fixed income securities; broad
market indices such as this one can be subdivided
Dimensions of Fixed Income Indices
Market
Type
Maturity
Credit Quality

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7. Indices for Alternative Investments

Commodity Indices consist of futures contracts on one or more commodities
Performance of index and underlying commodities can be different
Common to have multiple indices with same commodities but in different
proportions; weighting methods also different; different risk return profile
Real estate indices represent market for real estate securities and the market for
real estate
Appraisal indices, repeat sales indices, REIT indices
Hedge fund indices reflect the returns on hedge funds
Constituents determine the index
Poorly performing hedge funds are less likely to report
Index returns overstated due to survivorship bias

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Summary
Constructing and managing an index

Target market and security selection

Price return and total return
Weights
Rebalancing and Reconstitution

Uses of security market indices

Equity, fixed income and alternative investment indices
Representative indices worldwide (last part of the reading)

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Conclusion
Read the summary
Review learning objectives
No blue box examples
Practice problems
Practice questions from other sources
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