LCASTOL

CHAPTER 5
SECURITY MARKET INDEXES
 LCASTOL
LEARNING OBJECTIVES
CH. 5 – Security Market Indexes

Learning Objectives
• Enumerate and explain the uses of security-market indices
• Describe major characteristics that cause alternative indexes to
differ
• Explain why bond indexes are more difficult to create and
maintain than stock indexes
• Identify US and global stock and bond indexes and their
characteristics
• Explain composite stock-bond indexes
• Explain the relationship among many of these indexes in the
short-run
 SECURITY MARKET INDEXES
Uses
• As benchmarks to evaluate the performance of professional
money managers
• To create and monitor an index fund
• To measure market rates of return in economic studies
• For predicting future market movements by technicians
• As a substitute for the market portfolio of risky assets when
calculating the systematic risk of an asset

Factors Affecting Market Indexes

• The Sample (size, breadth, source)
• Computational Procedure
• Weighting of Sample Members
• Price-weighted index
• Value-weighted index
• Unweighted (equally weighted) index
• Fundamental weighted index

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 STOCK MARKET INDEXES
Type Description & Formula Examples
• Each company's stock is weighted by its price per share, and the index is an • Dow Jones (DJIA)
average of the share prices of all the companies. • Nikkei
• Price-weighted indexes give greater weight to stocks with higher prices in
terms of their contribution to the index value and changes in the index.
• To calculate the value of a simple price-weighted index, find the
Price-weighted sum of the share prices of the individual companies, and divide by
the number of companies.
• In some averages, this divisor is adjusted in the event of stock splits
or changes to the index list of companies in

• Derive the initial total market value of all stocks used in the series • NYSE Composite
• Market Value = Number of Shares Outstanding • S&P 500
X Current Market Price
Value-weighted • Assign an beginning index value (100) and new market values are compared
to the base index
• Automatic adjustment for splits
• Weighting depends on market value

Free-float market • Similar to value-weighted but only considers free-floating shares in the • PSEi
capitalization computation of the market value of the stock

*Free float, also known as public float, refers to the shares of a company that can be publicly traded and are not restricted
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 STOCK MARKET INDEXES
Type Description & Formula Examples
• All stocks carry equal weight regardless of price or market • Financial Times
value Ordinary Share Index
• May be used by individuals who invest the same dollar (FTSE)
Unweighted amount in each stock • Value Line Average
• Some use arithmetic average of the percent price changes
for the stocks in the index

• A fundamentally weighted index, or fundamental index, is • FTSE RAFI US 1000

one in which the equity components were chosen based on Index
criteria other than market capitalization.
• For example, a fundamentally weighted index can be
Fundamentally- based on revenue, dividend yields, earnings, or other
weighted fundamental factors.
• Fundamentally weighted indexes are some of the most
prominent customized indexes used by passively managed
tracker funds.

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 DOW JONES INDUSTRIAL AVERAGE (DJIA)
Description
• Best-known, oldest, most popular index
• Price-weighted average of thirty large well-known
industrial stocks, leaders in their industry, and listed
on NYSE
• Total the current price of the 30 stocks and divide it
by a divisor (adjusted for stock splits and changes in
the sample)
Criticism
• Limited to 30 non-randomly selected blue-chip
stocks
• Does not represent a vast majority of stocks
• The divisor needs to be adjusted every time one of
the companies in the index has a stock split
• Introduces a downward bias by reducing weighting
of fastest growing companies whose stock splits

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 DJIA – EFFECT OF CHANGES IN STOCK PRICE
• The example demonstrates the impact of differently priced shares on a price-weighted index.
• It shows that higher priced stock will affect the index more (Case A) than lower priced stock (Case B).

Stock Period T Case A (T+1) Case B (T+1)

A 100 110 (+10%) 100
B 50 50 50
C 30 30 33 (+10%)
Sum 180 190 183
Divisor 3 3 3
Average 60 63.3 61
Percentage Change - 5.5% 1.7%
 DJIA – EFFECT OF STOCK SPLIT
• Assume the index price-weighted index consists of three stocks, A, B, and C.
• This example illustrates how the index and the new divisor are computed before and after a 3-for-1 stock
split for Stock A

Stock Price Before Split Price After Split

A 30 10
B 20 20
C 10 10
Index = 60/3 = 20 40/X = 20
Divisor 3 X=2

• Index must not change after stock splits

• Divisor changes
 NIKKEI DOW JONES AVERAGE (NIKKEI)

Description
• Arithmetic average of prices for 225 stocks on the
First Section of the Tokyo Stock Exchange (TSE)
• Best-known series in Japan
• Price-weighted series formulated by Dow Jones and
Company
• The 225 stocks represent 15 percent of all stocks on
the First Section

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MARKET VALUE INDEX – EFFECT OF CHANGES IN STOCK PRICE
• Index is greatly affected by movements of larger market-value stocks of the index
• Automatically adjusts for stock splits
MARKET VALUE INDEX VS EQUAL WEIGHTED

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 PHILIPPINE STOCK EXCHANGE INDEX (PSEi)
• Composed of only 30 ”blue-chip” company stocks
that are market leaders in their sectors and widely
traded
• Computed using a free-float market-weighted
formula
• Reviewed semi-annually for recomposition
• Sector Indices. (1) Financials Index; (2) Industrial
Index; (3) Holding Firms Index; (4) Property
Index; (5) Services Index; and (6) Mining & Oil
Index.
• All Shares Index. It is considered a broader
barometer including all the common stocks of
companies listed at the Exchange.. The full market
capitalization method is used in computing the All
Shares Index. The All Shares index excludes those
listed in the Small, Medium and Emerging (SME)
Board.
 INVESTMENT STYLES
Growth Investing
• Growth stocks represent companies that have
demonstrated better-than-average gains in earnings
in recent years and that are expected to continue
delivering high levels of profit growth
• "Emerging" growth companies are those that have
the potential to achieve high earnings growth, but
have not established a history of strong earnings
growth.
The key characteristics of growth funds are as follows:
• Higher priced than broader market.
• High earnings growth records
• More volatile than broader market
Style Investing
• Value fund managers look for companies that have
fallen out of favor but still have good fundamentals.
• The value group may also include stocks of new
companies that have yet to be recognized by
investors.
• The key characteristics of value funds include:
• Lower priced than broader market.
• Priced below similar companies in industry.
• Carry somewhat less risk than broader market.
 STYLE INDICES
Definition
• Style indexes can be categorized according to market cap, value or growth, or a combination of these
characteristics. They are intended to reflect the investing styles of certain investors, such as the small-cap
investor, growth investor, and value investor.
• Some indexes reflect a combination of the market cap, and growth or value styles. Combining the three market-
cap groups with value and growth classifications results in the following six basic style index categories:

Growth Style Indexes
• Small-cap growth
• Mid-cap growth
• Large-cap growth
Value Style Indexes
• Small-cap value
• Mid-cap value
• Large-cap value
Socially Responsible
Investment (SRI) Indexes*
• By country
• Global ethical stock
index
• Social, environmental
and governance
• Examples: MSCI SRI
 GLOBAL EQUITY INDICES
Description
• There are stock-market indexes available for most individual foreign markets
• These are closely followed within each country
• These are difficult to compare due to differences in sample selection, weighting, or computational procedure
• Groups have computed country indexes

Type Description
• Jointly compiled by The Financial Times Limited, Goldman Sachs & Company, and Standard & Poor’s in
conjunction with the Institute of Actuaries and the Faculty of Actuaries
• Measures 2,500 securities in 30 countries
• Covers 70% of the total value of all listed companies in each country
• Includes actively traded medium and small corporations along with major international equities
FT/S&P • Securities included must allow direct holdings of shares by foreign nationals
Actuaries • Index is market-value weighted with a base date of December 31, 1986 = 100
World Indexes • Index results are reported in U.S. dollars, U.K. pound sterling, Japanese yen, German mark, and the local
currency of the country included
• Results are calculated daily after the New York markets close and published the following day in the
Financial Times
• Geographic subgroups are also published

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 GLOBAL EQUITY INDICES
Type Description
• Three international, nineteen national, and thirty-eight international industry indexes
• Include 1,673 companies listed on stock exchanges in 22 countries with a combined
capitalization representing approximately 60 percent of the aggregate market value of the
stock exchanges of these countries
• All the indexes are market-value weighted
• Reporting is in U.S. dollars and the country’s local currency
• Also provides
Morgan Stanley • price to book value (P/BV) ratio
Capital International • price to cash earnings (earnings plus depreciation) (P/CE) ratio
(MSCI) Indexes • price to earnings (P/E) ratio
• dividend yield (YLD)
• The Morgan Stanley group index for Europe, Australia, and the Far East (EAFE) is used as
the basis for futures and options contracts on the Chicago Mercantile Exchange and the
Chicago Board Options Exchange
• Tracked by PH investors especially changes in weighting of PSEi member stocks

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MSCI INDICES
MSCI INDICES
 GLOBAL EQUITY INDICES
Type Description
• Introduced in January 1993
• 2,200 companies worldwide
• Organized into 120 industry groups
• Includes 33 countries representing more than 80 percent of the combined capitalization of
Dow Jones World these countries
Stock Index • Countries are grouped into three major regions: Asia/Pacific, Europe/Africa, and the
Americas
• Each country’s index is calculated in its own currency as well as in the U.S. dollar

Comparison of World Stock Indexes

• The three indexes by Financial Times (FT),
Morgan Stanley (MS), and Dow Jones (DJ) are
closely correlated
• Correlations between the three series since
December 31, 1991 to December 31, 2007,
indicates an average correlation coefficient in
excess of 0.99
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 BOND MARKET INDICES
Basic Concept
• Relatively new and not widely published
• Growth in fixed-income mutual funds increase need for reliable
benchmarks for evaluating performance
• Many managers have not matched aggregate bond market return
• Increasing interest in bond index funds
• Requires an index to emulate

Difficulties in Creating the Bond Index

• Universe of bonds is much broader than that of stocks
• Range of bond quality varies from U.S. Treasury securities
to bonds in default
• Bond market changes constantly with new issues,
maturities, calls, and sinking funds
• Bond prices are affected by duration, which is dependent on
maturity, coupon, and market yield
• Correctly pricing individual bond issues without current and
continuous transaction prices available poses significant
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problems
 BOND MARKET INDICES
Type Description
• Four investment firms maintain indexes for Treasury bonds and other investment grade
(rated BBB or Baa or higher) bonds
US Investment • Relationship among these bonds is strong (correlations average 0.95)
Grade Bond Indexes • Returns for all these bonds are driven by aggregate interest rates - shifts in the
government yield curve
• Non-investment-grade bonds (Rated Ba, B, Caa, Ca, and C)
High-Yield Bond • Four investment firms and two academicians created indexes
Indexes • Relationship among alternative high-yield bond indexes is weaker than among investment
grade indexes
• Global bond market dominated by government issues
• Several indexes created by major investment firms
• Measure total rates of return
• Use market-value weighting
Global Bond Govt. • Use trader pricing
Bond Indexes • But sample sizes and numbers of countries differ
• Differences affect long-term risk-return performance
• Low correlation among several countries
• Significant exchange rate effect on volatility and correlations
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 COMPOSITE STOCK-BOND INDEXES
Purpose
• Beyond separate stock indexes and bond indexes for individual countries, a natural step is a composite series that
measures the performance of all securities in a given country
• This allows examination of benefits of diversification with a combination of asset classes such as stocks and bonds in
addition to diversifying within the asset classes of stocks or bonds
Examples
• Merrill Lynch-Wilshire U.S. Capital Markets Index (ML-WCMI)
• Market-value weighted index measures total return performance of the combined U.S. taxable fixed income and equity
markets
• Combination of Merrill-Lynch fixed-income indexes and the Wilshire 5000 common-stock index
• Tracks over 10,000 stocks and bonds
• Brinson Partners Global Security Market Index (GSMI)
• Includes:
• U.S. stocks and bonds
• Non-U.S. equities
• Non-dollar bonds
• Allocation to cash
• Matches a typical U.S. pension fund allocation policy
a referred to in the CAPM literature
• Close to the theoretical “market portfolio of risky assets”
 COMPARISON OF INDEXES OVER TIME

Correlations Among Monthly Equity Price Changes

• Most differences are attributable to sample differences
• Different segments of U.S. stock market or from different countries
• Lower correlations between NYSE series and AMEX series or NASDAQ index than between NYSE alternative series
Correlations Among Monthly Bond Indexes
• Among investment-grade bonds correlations range from 0.90 to 0.99
• Interest rates differ by risk premiums
• Rates of return are determined by systematic interest rate variables
• Low correlation in global returns to U.S. returns support global diversification
 COMPARISON OF INDEXES OVER TIME
Mean Annual Security Returns and
Risk
• There are clear differences among the
series due to different asset classes
(e.g., stocks vs. bonds) and different
samples within asset classes
• There is a positive relationship between
the average rate of return on an asset
and its measure of risk
• The security market indexes can be
used
• To measure the historical
performance of an asset class
• As benchmarks to evaluate the
performance of a money manager
for a mutual fund, a personal trust,
or a pension plan