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Level I – Equity Investments

Security Market Indices

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Contents

1. Introduction

2. Index Definition and Calculations of Value and Retur

3. Index Construction and Management

4. Uses of Market Indices

5. Equity Indices

6. Fixed-Income Indices

7. 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 re

performance of the U.S. stock market

• Now security market indices have multiple uses that help an investor tr

performance of various markets, estimate risk and evaluate the perfor

investment

• Major indices include S&P 500, FTSE and Nikkei

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2. Index Definition and Calculations of Value and

• Security market indices measure the value of different target

(security markets, market segments, asset classes)

• Index value is calculated on a regular basis using actual or es

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 holdi

returns

• Calculation of index values over multiple periods is done by linking retu

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3. Index Construction and Managem

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Which target market should the index represent?

Which securities should be selected from that targetmarket?

How much weight should be allocated to each securityin the index?

When should the index be rebalanced?

When should the security selection and weighteddecision be re-examined?

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Target Market and Security Selectio

• 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 ot

characteristics

• Target market determines the investment universe

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d h

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Index Weighting

Index weighting determines how much of each security to inclu

index. This decision impacts index value. The major index weig

methods are:

• Price Weighting

• Equal Weighting

• Market-Capitalization Weighting

• Fundamental Weighting

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i i h i

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Price Weighting

The weight on each security is determined by dividing its price by the sum

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BOP

Price

BOP

Wgt

EOP

Price

Div/

ShareA 4 20% 2 0

B 6 30% 6 1

C 10 50% 14 2

Using a divisor of 3, compute 1) index

the price return and total return.

If there is a 2-for-1 split in Stock C dur

period, what is impact on the index va

return calculations?

What are the pros and cons of the pric

method?

E l W i h d I d

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Equal Weighted Index

Assign equal weight to each constituent security at inception

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BOP

Price

EOP

Price

Div/

ShareA 4 2 0

B 6 6 1

C 10 14 2

Compute the price return and total re

How can you create an equal weighted

What are the pros and cons of the equ

method?

M k t C it li ti W i ht d I d

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Market Capitalization Weighted Ind

Weight of each security is determined by dividing its market capitalization

market capitalization

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# of

Shares

BOP

Price

EOP

Price

Div/

Share

A 500 4 2 0

B 100 6 6 1

C 100 10 14 2

What divisor must be used su

initial index value is 1000?

Compute the 1) final index va

return and total return.

Compute the price return if S

market float of 40%.

What are the pros and cons o

capitalization weighting meth

F d t l W i hti

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Fundamental Weighting

Fundamental weighting uses measures such as book value, cash flow, reve

earnings and dividends to calculate the weight of each security

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# of

Shares

BOP

Price

Earning EOP

Price

A 500 4 20 2

B 100 6 20 6

C 100 10 20 14

Compute the price return.

What are the pros and cons of the

weighting method?

Note the value tilt.

S f R lt

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Summary of Results

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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# of

Shares

BOP

Price

EOP

Price

Earnings Div/

Share

A 500 4 2 20 0

B 100 6 6 20 1

C 100 10 14 20 2

P /C f I d W i hti M th

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Pros/Cons of Index Weighting Metho

Method Pros Cons

Price Simple Arbitrary weights

Equal Simple High market cap stock under-

Requires frequent rebalancin

Market Cap Securities held in

proportion to their value

Influenced by overpriced secu

Fundamental Value tilt Does not consider market val

Requires rebalancing

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I d M t R b l i d R t

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Index Management: Rebalancing and Reconst

• Rebalancing means adjusting weights of constituent securiti

Important for equal-weighted indices

• Reconstitution means changing constituent securities

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4 Uses of Market Indices

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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 ad

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

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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

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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 availabl

• 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; b

market indices such as this one can be subdivided

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Dimensions of Fixed Income Indices

Market

Type

Maturity

Credit Quality

7 Indices for Alternative Investmen

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7. Indices for Alternative Investmen

• Commodity Indices consist of futures contracts on one or more commo

Performance of index and underlying commodities can be different

Common to have multiple indices with same commodities but in dif

proportions; weighting methods also different; different risk return

• Real estate indices represent market for real estate securities and the m

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

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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 indic• Representative indices worldwide (last part of the rea

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Conclusion

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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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