Chapter No 2: Security Markey Indices

1. Security market indices: have evolved into important multi-purpose tools that help investors
track the performance of various security markets, estimate risk, and evaluate the performance
of investment managers. They also form the basis for new investment products.
2. A security market index represents a given security market, market segment, or asset class.
Most indices are constructed as portfolios of marketable securities.
3. The value of an index is calculated on a regular basis using either the actual or estimated market
prices of the individual securities, known as constituent securities.
4. A price return index, also known as a price index, reflects only the prices of the constituent
securities within the index.
5. A total return index, in contrast, reflects not only the prices of the constituent securities but also
the reinvestment of all income received since inception.
6. The divisor is a number initially chosen at inception. It is frequently chosen so that the price
index has a convenient initial value, such as 1,000.
7. The index provider then adjusts the value of the divisor as necessary to avoid changes in the
index value that are unrelated to changes in the prices of its constituent securities.
8. Price return can be calculated either as the percentage change in the value of the price return
index or the weighted average of price returns of the constituent securities where the weights
are based on beginning-of-period values.

VPRI 1 − VPRI 0 N N
P −P 
PR I = =  w i PR i =  w i  i1 i 0 
VPRI 0 i =1 i =1  Pi 0 

PR = the price return of index portfolio I

I

PR = the price return of constituent security i

i

w = the weight of security i

i

P = the price of constituent security i at the end of the period

i1

P = the price of constituent security i at the beginning of the period

i0

9. Choices in index construction:

• What target market should the index represents
• Which securities should be chosen from the target market
• How much weight should be allocated to each secondary market
• When should be the index be rebalanced
• When should be the security selection and waiting decision can be re examined

10. Weighting methods used in index construction

• Price weighted:
In price weighting, the weight on each constituent security is determined by dividing its
price by the sum of all the prices of the constituent securities. A property unique to
price-weighted indices is that a stock split on one constituent security changes the
weights on all the securities in the index.
Pi
w iP = N

P
i =1
i

➢ Advantages:
▪ The primary advantage of price weighting is its
simplicity.
▪ Stock split results in arbitrary changes in weights.

➢ Disadvantages
▪ Its primary disadvantage is the stocks with the highest
price have the greatest impact on index return.
• Equally weighted:
Unlike a price-weighted index, where the weights are arbitrarily determined by the
market prices, the weights in an equal-weighted index are assigned by the index
provider.

1
w iE =
N
➢ Advantages:
▪ The primary advantage of equal weighting is its
simplicity.

➢ Disadvantages
▪ First, securities that constitute the largest fraction of the
target market value are underrepresented, and
securities that constitute a small fraction of the target
market value are overrepresented.
▪ Second, after the index is constructed and the prices of
constituent securities change, the index is no longer
equally weighted. Therefore, maintaining equal weights
requires frequent adjustments (rebalancing) to the
index.
• Market capitalization weighted:
In market-capitalization weighting, the weight on each constituent security is
determined by dividing its market capitalization by the total market capitalization of all
the securities in the index. Market-capitalization weighting is sometimes called value
weighting. Market capitalization or value is calculated by multiplying the number of
shares outstanding by the market price per share.
 Market Capitalization= No of shares * market price per share

Qi Pi
w iM = N

Q P
j =1
j j

➢ Advantages:
▪ The primary advantage of market-capitalization
weighting (including float adjusted) is that constituent
securities are held in proportion to their value in the
target market.
➢ Disadvantages
▪ This weighting method leads to overweighting stocks
that have risen in price (and may be overvalued) and
underweighting stocks that have declined in price (and
may be undervalued).

• Momentum investment strategy: The effect of this weighting method is similar to a momentum
investment strategy in that over time, the securities that have risen in price the most will have
the largest weights in the index.

• Fundamental weighted:
Fundamental weighting uses measures of a company’s size that are independent of its
security price to determine weights. These measures include book value, cash flow,
revenues, earnings, dividends, and number of employees.

Fi
w iF = N

F j =1
j

➢ Advantages:
▪ The most important property of fundamental weighting
is that it leads to indices that have a “value” tilt. That is,
a fundamentally weighted index has ratios of book
value, earnings, dividends, etc. to market value that are
higher than its market-capitalization-weighted
counterpart
➢ Disadvantages
▪ Data intense
11. Why Rebalancing is necessary?

• Rebalancing may become necessary as market prices change as that will change the
weights of the constituent securities in the index.
• Price-weighted indices: No rebalanced
• Market-capitalization-weighted indices: Rebalancing is less of a concern
12. Re-constitution

Reconstitution is the process of changing the constituent securities in an index. Initial criteria for
index inclusion are applied on the reconstitution date to determine which securities to retain,
remove, or add.

13. Uses of market induces

• The original purpose of stock market indices was to provide a gauge of investor confidence or
market sentiment.
• Market induces are proxies for measuring and modeling returns, systematic risk, and risk-
adjusted performance.
• Market indices are proxies for asset classes in asset allocation models
• Market indices are benchmarks for actively managed portfolios
• Market indices are model portfolios for such investment products as index funds and exchange-
traded funds (ETFs)
14. Broad market equity indices typically include securities representing more than 90 percent of
the selected market.

15. Multimarket equity indices usually comprise indices from different countries and are designed
to represent multiple security markets. MSCI Barra offers a number of multi-market indices.

16. Sector indices represent and track different economic sectors—such as consumer goods, energy,
finance, health care, and technology—on either a national, regional, or global basis.

17. Style indices represent groups of securities classified according to market capitalization, value,
growth, or a combination of these characteristics. They are intended to reflect the investing
styles of certain investors, such as the growth investor, value investor, and small-cap investor.

18. Challenges Facing Fixed Income Index Construction

• Larger number of securities
• Illiquid securities
• Lack of pricing data
19. Indices for alternative investments
• Commodities
• Real estate
• Hedge funds
20. Features of commodities induces
• Risk free interest rate
• Changes in future prices
• Roll yield
21. Features of Hedge funds indices
• Hedge funds are private investment vehicles that typically use leverage and long and short
investment strategies
• Research organizations maintain databases of hedge fund returns and summarize these
returns into indices
• Most indices reflect performance on a broad global level or on a strategy level.
• Most indices are equal weighted