Security Analysis & Portfolio Management

Security Market Indexes

Report

Submitted by:
Group No: B6
Kavisha Mittal (p39136)
Maitri Patel (p39139)
Minil Patel (p39143)
Mukul Verma (p39144)
Nishant Mehta (p39148)
Parth Sarthi (p39150)
Pragya Aggarwal (p39152)
Prakash Pachar (p39153)
Contents
1.0 INTRODUCTION ......................................................................................................................................... 3
1.1 ORIGIN OF MARKET INDEXES ................................................................................................................ 3
2.0 INDEX DEFINITION AND VALUE CALCULATIONS ....................................................................................... 3
2.1 INDEX DESCRIPTION AND COST AND RETURN CALCULATIONS ............................................................ 4
2.1.1 SINGLE-PERIOD RETURNS .............................................................................................................. 4
3.0 INDEX CONSTRUCTION AND MANAGEMENT ........................................................................................... 4
3.1 TARGET MARKET AND SECURITY SELECTION ........................................................................................ 5
4.0 INDEX WEIGHTING .................................................................................................................................... 5
5.0 PRICE WEIGHTING ..................................................................................................................................... 6
6.0 EQUAL WEIGHTING ................................................................................................................................... 6
7.0 MARKET-CAPITALIZATION WEIGHTING .................................................................................................... 7
8.0 FLOAT-ADJUSTED MARKET-CAPITALIZATION WEIGHTING ....................................................................... 7
9.0 FUNDAMENTAL WEIGHTING..................................................................................................................... 8
9.1 INDEX MANAGEMENT: REBALANCING AND RECONSTITUTION ....................................................... 9
9.1.1 REBALANCING ................................................................................................................................ 9
9.1.2 RECONSTITUTION......................................................................................................................... 10
10.0 USES OF MARKET INDEXES ................................................................................................................... 10
10.1 GAUGES OF MARKET SENTIMENT..................................................................................................... 11
10.2 Proxies for Measuring and Modeling Returns, Systematic Risk, and Risk-Adjusted Performance... 11
10.3 BENCHMARKS FOR ACTIVELY MANAGED PORTFOLIOS .................................................................... 12
SUMMARY ..................................................................................................................................................... 12
1.0 INTRODUCTION
Investors are continually collecting and analyzing vast amounts of security market information.
Because this work can be time-consuming as well as data-intensive, investors often use a single
measure to consolidate this information and reflect the performance of a whole security market.

Market indexes for security were first introduced as a simple measure to reflect U.S. stock market
performance. Security market indexes have since evolved into significant multi-purpose tools that
help investors track the performance of different security markets, estimate risk, and evaluate
investment managers ' performance. They are also the foundation for new investment products

1.1 ORIGIN OF MARKET INDEXES

Investors had access to regularly published data on individual security prices in London as early
as 1698, but nearly 200 years passed before they had access to a simple indicia- tor to reflect
security market information. To give readers a sense of how the US stock market in general
performed on a given day, publishers Charles H. Dow and Edward D. Jones introduced the Dow
Jones Average, the world’s first security market index, in 1884. The index, which appeared in The
Customers’ Afternoon Letter, consisted of the stocks of nine railroads and two industrial
companies. It eventually became the Dow Jones Transportation Average. Convinced that
industrial companies, rather than railroads, would be “the great speculative market” of the future,
Dow and Jones introduced a second index in May 1896—the Dow Jones Industrial Average
(DJIA). It had an initial value of 40.94 and consisted of 12 stocks from major US industries.
Today, investors can choose from among thousands of indexes to measure and monitor different
security markets and asset classes.

2.0 INDEX DEFINITION AND VALUE CALCULATIONS

A security market index is a security market, market segment, or asset class. Most indexes are
designed as marketable securities portfolios.

The value of an index is periodically determined using the real or expected market prices of the
individual securities, known as constituent securities, inside the list. Investors that consider two
versions of the same index (i.e. an index with similar securities and weights) for each security
market index: one based on price return and one based on total return. As the name suggests, only
the prices of the constituent securities within the index are expressed in a price return index, also
known as a price index. In comparison, a total return index represents not only the constituent
stock rates, but also the reinvestment of all income received since its inception.

2.1 INDEX DESCRIPTION AND COST AND RETURN CALCULATIONS

The cost and maximum return versions of an index are identical at the beginning. However, as
time goes by, the value of the total return index, which includes reinvesting all dividends and/or
interest received, will exceed by an increasing amount the value of the price return index. A look
at how each version's values are measured over multiple periods reveals why.

Index return estimates, such as investment portfolio return calculations, can calculate price returns
or total returns. Price returns only calculate price appreciation or price change percentage. Total
price appreciation calculations plus interest, dividends, and other distributions.

2.1.1 SINGLE-PERIOD RETURNS

The price return can be calculated in two ways for a security market index: either the percentage
change in the value of the price return index or the weighted average price return of the
constituent securities.

Total price appreciation of return steps plus interest, dividends and other disbursements.
Therefore, an index's total return is the price appreciation or adjustment in the price return index
value plus income (dividends and/or interest) over the duration, expressed as a percentage of the
price return index's starting value.

An index's total return may also be calculated as the weighted average of the constituent securities
' total returns.

3.0 INDEX CONSTRUCTION AND MANAGEMENT

The development and management of a security market index is similar to the creation and
management of a securities portfolio.

1. Index providers have to decide which target market should be represented by the index?
2. Which securities from that target market should be selected?
 3. How much weight should be allocated in the index for each security?
4. When is it appropriate to rebalance the index?
5. When is the re-examination of the safety collection and weighting decision?

3.1 TARGET MARKET AND SECURITY SELECTION

The first index judgment determines the target market, market segment, or asset class to be
identified by the index. It is possible to define the target market very loosely or narrowly. It may
be based on asset class (for instance, equity, fixed income, real estate, energy, hedge funds);
geographic region (for example, Japan, South Africa, Latin America, Europe); the exchange on
which the securities are traded (e.g., Shanghai, Toronto, Tokyo), and/or other characteristics (e.g.,
economic sector, company size, investment style, duration, or credit quality).

The target market determines the investment universe and the securities available for inclusion in
the index. Once the investment universe is identified, the number of securities and the specific
securities to include in the index must be determined.

Nearly all those in the target market or a representative sample of the target market could be
constituent securities. Many stock indices, such as the S&P 500 Index and the FTSE 100,
determine the number of stocks included in the index and denote the number in the index name.
Other indexes allow the number of securities to vary in order to reflect or maintain changes in the
target market. The Tokyo Stock Price Index (TOPIX), for example, reflects and contains all the
largest stocks listed on the Tokyo Stock Exchange, defined as the First Page. In order to be
included in the First Section— and therefore the TOPIX — stocks must meet certain criteria, such
as the amount of outstanding shares, the number of investors and market capitalization. Objective
or mechanical rules determine the constituent securities of most, but not all, indexes. The Sensex
of Bombay and the S&P 500, for example, use a selection committee and more subjective
decision-making rules to determine constituent securities.

4.0 INDEX WEIGHTING

The weighting choice decides the amount of every security to remember for the record and
substantially affects a list's worth. Record suppliers utilize various techniques to weight the
constituent protections in a file. Files can be cost weighted, equivalent weighted, advertise
capitalization weighted, or in a general sense weighted. Each weighting strategy has its favorable
circumstances and weaknesses.

5.0 PRICE WEIGHTING

The easiest strategy to weight a list and the one utilized by Charles Dow to build the Dow Jones
Industrial Average is value weighting. In value weighting, the weight on every constituent
security is dictated by isolating its cost by the entirety of the considerable number of costs of the
constituent protections.

A property one of a kind to cost weighted lists is that a stock split on one constituent security
changes the loads on every one of the protections in the index. To anticipate the stock split and the
subsequent new loads from changing the estimation of the file, the file supplier must alter the
estimation of the divisor.

The essential bit of leeway of value weighting is its straightforwardness. The principle weakness
of value weighting is that it brings about subjective loads for every security. In particular, a stock
split in any one security causes discretionary changes in the loads of the considerable number of
constituents' protections.

6.0 EQUAL WEIGHTING

Another straightforward list weighting strategy is equivalent weighting. This technique allocates
an equivalent load to every constituent security at initiation.

Like value weighting, the essential bit of leeway of equivalent weighting is its
straightforwardness. Equivalent weighting, in any case, has various burdens. To begin with,
protections that constitute the biggest portion of the objective market esteem are underrepresented,
and securities that comprise a little division of the objective market esteem are overrepresented.
Second, after the record is developed and the costs of constituent protections change, the list is
never again similarly weighted. Accordingly, keeping up equivalent loads requires visit alterations
(rebalancing) to the list.
7.0 MARKET-CAPITALIZATION WEIGHTING
In showcase capitalization weighting, or worth weighting, the weight on each constituent security
is controlled by separating its market capitalization by the all out market capitalization (the
aggregate of the market capitalization) of the considerable number of protections in the list.
Market capitalization or worth is determined by increasing the quantity of offers out-remaining by
the market cost per share.

To comprehend the source and greatness of the distinction, look at the loads and returns of every
security under every one of the weighting strategies. The heaviness of Security A, for instance,
ranges from 49.26 percent in the value weighted record to 20 percent in the equivalent weighted
file. With a value return of 10 percent, Security A contributes 4.93 percent to the value return of
the value weighted record, 2.00 percent to the value return of the equivalent weighted list, and
2.63 percent to the value return of the market-capitalization-weighted list. With an all out return of
11.50 percent, Security A contributes 5.66 percent to the all out return of the value weighted
record, 2.30 percent to the absolute return of the equivalent weighted file, and 3.02 percent to the
complete return of the market-capitalization-weighted list.

8.0 FLOAT-ADJUSTED MARKET-CAPITALIZATION WEIGHTING

In coast balanced market-capitalization weighting, the weight on every constituent security is
controlled by modifying its market capitalization for its market glide. Ordinarily, advertise glide is
the quantity of portions of the constituent security that are accessible to the contributing open. For
organizations that are firmly held, just a segment of the offers extraordinary are profit ready to the
contributing open (the rest are held by a little gathering of controlling financial specialists).
Notwithstanding barring offers held by controlling investors, most buoy balanced market-
capitalization-weighted files additionally avoid shares held by different enterprises and
governments. A few suppliers of files that are intended to speak to the contribute meant chances
of worldwide speculators further lessen the quantity of offers remembered for the list by barring
shares that are not accessible to outsider financial specialists. The list suppliers may allude to
these files as "free-drift balanced market-capitalization-weighted lists.
Buoy balanced market-capitalization-weighted lists mirror the offers accessible for open
exchanging by duplicating the market cost per share by the quantity of offers accessible to the
contributing open (i.e., the buoy balanced market capitalization) instead of the absolute number of
offers exceptional (all out market capitalization). Right now, most market-capitalization-weighted
files are coast balanced. In this way, except if otherwise demonstrated, for the rest of this
perusing, "showcase capitalization" weighting alludes to glide balanced market-capitalization
weighting.

The low level of portions of Security D in the market skim contrasted and the quantity of offers
exceptional demonstrates that the security is firmly held.

The essential favorable position of market-capitalization weighting (counting glide balanced) is

that constituent protections are held in relation to their incentive in the objective blemish ket. The
essential inconvenience is that constituent protections whose costs have risen the most (or fallen
the most) have a more prominent (or lower) weight in the file (i.e., as a security's cost rises
comparative with different protections in the list, its weight increments; and as its value
diminishes in esteem comparative with different protections in the file, its weight diminishes).
This weighting technique prompts overweighting stocks that have ascended in cost (and might be
exaggerated) and underweighting stocks that have declined in cost (and might be underestimated).
The impact of this weighting technique is like an energy speculation system in that after some
time, the protections that have ascended in value the most will have the biggest loads in the
record.

9.0 FUNDAMENTAL WEIGHTING

Fundamental weighting attempts to address the market capitalization weighting disadvantages
by using measurements of the size of a company that are independent of its security price to
determine the weight of each constituent security. These include book value, cash flow, sales,
earnings, dividends, and employee numbers. Many fundamental indices use a single measure
to weigh the constituent securities, such as total dividends, while others combine the weights
from different factors to form a standardized value used to calculate.

Relative to a market-capitalization-weighted index, a essential index with weights primarily

based on such an item as income will bring about extra weights on constituent securities with
earnings yields (earnings divided by using price) which might be higher than the income yield
of the overall market-weighted portfolio. Similarly, stocks with earnings yields less than the
yield on the overall market-weighted portfolio can have lower weights.

9.1 INDEX MANAGEMENT: REBALANCING AND RECONSTITUTION

So far, we have discussed index construction. Index

management entails the two remaining questions:

■ when should the index be rebalanced?

■ when should the security selection and weighting decisions be re-examined?

9.1.1 REBALANCING
Rebalancing refers to adjusting the weights of the constituent securities in the index. To
maintain the weight of each security consistent with the index’s weighting method, the index
provider rebalances the index by adjusting the weights of the constituent securities on a
regularly scheduled basis (rebalancing dates)—usually quarterly. Rebalancing is necessary
because the weights of the constituent securities change as their market prices change. Note,
for example, that the weights of the securities in the equal-weighted index (Exhibit 3) at the
end of the period are no longer equal (i.e., 20 percent):

Security A 19.93
Security B 15.94
Security C 11.60
Security D 25.36
Security E 27.17

In rebalancing the index, the weights of Securities D and E (which had the highest returns)
would be decreased and the weights of Securities A, B, and C (which had the lowest returns)
would be increased. Thus, rebalancing creates turnover within an index. Price-weighted
indexes are not rebalanced because the weight of each constituent security is determined by
its price. For market-capitalization-weighted indexes, rebalancing is less of a concern
because the indexes largely rebalance themselves. In our market-capitalization index, for
example, the weight of Security C automatically declined from 10.96 percent to 6.91
percent, reflecting the 36 percent decline in its market price. Market-capitalization weights
are only adjusted to reflect mergers, acquisitions, liquidations, and other corporate actions
between rebalancing dates.

9.1.2 RECONSTITUTION
Reconstitution is the process of changing the constituent securities in an index. It is similar
to a portfolio manager deciding to change the securities in his or her port- folio.
Reconstitution is part of the rebalancing cycle. The reconstitution date is the date on which
index providers review the constituent securities, re-apply the initial criteria for inclusion in
the index, and select which securities to retain, remove, or add. Constituent securities that
no longer meet the criteria are replaced with securities that do meet the criteria. Once the
revised list of constituent securities is determined, the weighting method is re-applied.
Indexes are reconstituted to reflect changes in the target market (bankruptcies, de-listings,
mergers, acquisitions, etc.) and/or to reflect the judgment of the selection committee.

Reconstitution creates turnover in a number of different ways, particularly for market-

capitalization-weighted indexes. When one security is removed and another is added, the
index provider has to change the weights of the other securities in order to maintain the
market-capitalization weighting of the index.

The frequency of reconstitution is a major issue for widely used indexes and their
constituent securities.

10.0 USES OF MARKET INDEXES

Indexes were initially created to give a sense of how a particular security market performed
on a given day. With the development of modern financial theory, their uses in investment
management have expanded significantly. Some of the major uses of indexes include:
■ gauges of 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 managed portfolios; and
■ model portfolios for such investment products as index funds and exchange- traded funds
(ETFs).

Investors using security market indexes must be familiar with how various indexes are
constructed in order to select the index or indexes most appropriate for their needs.

10.1 GAUGES OF MARKET SENTIMENT

The original purpose of stock market indexes was to provide a gauge of investor confidence or
market sentiment. As indicators of the collective opinion of market participants, indexes reflect
investor attitudes and behavior. The Dow Jones Industrial Average has a long history, is
frequently quoted in the media, and remains a popular gauge of market sentiment. It may not
accurately reflect the overall attitude of investors or the “market,” however, because the index
consists of only 30 of the thousands of US stocks traded each.

10.2 Proxies for Measuring and Modeling Returns, Systematic Risk, and Risk-Adjusted
Performance
The capital asset pricing model (CAPM) defines beta as the systematic risk of a security with
respect to the entire market. The market portfolio in the CAPM consists of all risky securities. To
represent the performance of the market portfolio, investors use a broad index. For example, the
Tokyo Price Index (TOPIX) and the S&P 500 often serve as proxies for the market portfolio in
Japan and the United States, respectively, and are used for measuring and modeling systematic
risk and market returns.

Security market indexes also serve as market proxies when measuring risk-adjusted performance.
The beta of an actively managed portfolio allows investors to form a passive alternative with the
same level of systematic risk.
10.3 BENCHMARKS FOR ACTIVELY MANAGED PORTFOLIOS
Investors often use indexes as benchmarks to evaluate the performance of active port- folio
managers. The index selected as the benchmark should reflect the investment strategy used by the
manager. For example, an active manager investing in global small-capitalization stocks should be
evaluated using a benchmark index, such as the FTSE Global Small Cap Index, which includes
4,600 small-capitalization stocks across 48 countries.

The choice of an index to use as a benchmark is important because an inappropriate index could
lead to incorrect conclusions regarding an active manager’s investment performance. Suppose that
the small-cap manager underperformed the small-cap index but outperformed a broad equity
market index. If investors use the broad market index as a benchmark, they might conclude that
the small-cap manager is earning his or her fees and should be retained or given additional
assets to invest. Using the small-cap index as a benchmark might lead to a very different
conclusion.

SUMMARY
Security showcase files are significant apparatuses for financial specialists, who can choose from
among a huge number of records speaking to an assortment of security markets, advertise
sections, and resource classes. These lists go from those speaking to the worldwide market for
significant resource classes to those speaking to elective interests in explicit geographic markets.
To profit by the utilization of security showcase lists, speculators must comprehend their
development and decide if the chose record is suitable for their motivations. As often as possible,
a list that is appropriate for one reason may not be appropriate for different purposes. Clients of
records must be comfortable with how different lists are developed so as to choose the file or lists
generally fitting for their needs.

Among the key focuses made in this perusing is the accompanying:

 Security showcase files are proposed to quantify the estimations of various objective markets
(security markets, advertise portions, or resource classes).
 The constituent protections chose for incorporation in the security advertise file are proposed
to speak to the objective market.
 A value return file reflects just the costs of the constituent protections.
 A all out return list reflects the costs of the constituent protections as well as the reinvestment
of all pay got since the beginning of the record.
 Methods used to weight the constituents of a record run from the very sim-ple, for example,
cost and equivalent weightings, to the more mind boggling, for example, advertise
capitalization and major weightings.
 Choices in file development—specifically, the decision of weighting strategy—influence list
valuation and returns.
 Index the executives incorporate 1) occasional rebalancing to guarantee that the list keeps up
proper weightings and 2) reconstitution to guarantee the list speaks to the ideal objective
market.
 Rebalancing and reconstitution make turnover in a record. Reconstitution can drastically
influence costs of present and planned constituents.
 Indexes fill an assortment of needs. They measure advertise conclusion and fill in as
benchmarks for effectively oversaw portfolios. They go about as intermediaries for estimating
precise hazard and hazard balanced execution. They additionally fill in as intermediaries for
resource classes in resource designation models and as model portfolios for speculation items.
 Investors can browse security advertise lists speaking to different resource classes, including
value, fixed-pay, item, land, and support stock investments files.
 Within most resource classes, list suppliers offer a wide assortment of lists, running from
expansive market files to exceptionally particular records dependent on the backer's
geographic locale, financial improvement gathering, or monetary segment or different
variables. Proper utilization of security showcase files relies upon understanding their
construction and the executive.