2015, Study Session # 13, Reading # 46

SECURITY MARKET INDICES

SMI
MP
CS
FI
REITS

= Security Market Index

= Market Price
= Constituent Securities
= Fixed Income
= Real Estate Investment Trusts

46.a

SMI to represent performance of an asset
class, security market or segment of market.

Index is numerical value calculated from MP of
constituent securities.

Index return %
in index value over a period
of time.

46.b

Index Return

Price Index

Return Index

Uses only the prices of the CS in

return calculations.

Uses price & income in return

calculation (total return).

If interim CF then total return >
price return.

Returns for a measurement period (multiple sub-periods).

= 1 + 1 + 1 + 1 + 1
Where
K = total no. of sub-periods, RSK = portfolio return during sub-period K

46.c

Index providers must have to decide about target
market, securities type & weight, rebalancing &
reconstitution.

Target market may be defined very broadly or
narrowly.

Selection process may be determined by an
objective rule or subjectively (by committee).

46.d

Price-Weighted Index

Weighting Methods

Equal-Weighted index

Market cap-Weighted Index

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Fundamental Weighting

2015, Study Session # 13, Reading # 46

46.d

Price-Weighted Index

Arithmetic avg. of prices of securities included in the index.

The divisor is adjusted for stock splits & index reconstitution
(index will be unaffected).

Price Weighted Index

Advantage

Disadvantage

Simple to compute

Results in arbitrary weights for

each security.
Equal-Weighted index

Arithmetic avg. return of the index stocks & matched by the return of a
portfolio with equal $ invested in each index stock.

Advantage simplicity.

Disadvantages frequent portfolio rebalancing (
transaction cost) &
small firm bias.

Market cap-Weighted Index

Each index component is weighted according to market cap (price no.
of shares outstanding).

Self rebalancing in case of stock splits or stock dividends.

Float-Adjusted Market Cap Weighted Index

Market float total value of shares actually available to public for
investing.

Free float market float - shares not available to foreign buyers.

Float adjusted index is calculated similar to value weighted (however
weights are calculated based on publicly available shares).

Market Cap Weighted Indexes

Advantage

Disadvantage

Index security weights represent proportion

of total market value.

Overvalued stocks are given higher weight

& vice versa (large market cap bias)

Fundamental Weighting

Weights based on firm fundamentals (e.g earnings, dividends etc), based
on single or some combination of fundamental measures.

Weights are unaffected by share prices.

Advantage avoids the market-cap weighted index bias.

Fundamental weighted index will actually have value tilt.

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2015, Study Session # 13, Reading # 46

46.e
Examples

47.f

Rebalancing

Reconstitution

Adjusting portfolios securities weight to their

target weights.

Rebalancing is done on periodic basis (usually
quarterly) & an issue for equal-weighted indexes.

Adding & deleting securities that make up an

index.

When security is added (deleted) to an index its
price
().

Addition & deletion requires other index
components weight adjustment.

46.g

Indexes have several uses;

Reflection of market sentiment (represent market return).

Benchmark of manager performance (benchmark should consistent with manager style).

Proxies for measuring and modeling returns

Measure of & risk-adjusted return.

Model portfolio for index funds and ETFs.

Proxies for asset classes in asset allocation models.

46.h

Types of Equity Indices

Broad Market Index

Multi-Market Index

Provides a measure of markets overall

performance.

Usually contains more than 90% of the markets
total value.

Constructed from indexes of markets in several

countries.

Used to measure equity return of a geographic
region, stage of economic development or
entire world.

Multi-Market Index with Fundamental Weighting

Sector Index

Market cap for securities with each country

then weight the country index return in global
index by a fundamental factor (e.g. GDP).

Prevent a country with high stock return from
being over weighted in multi-market index.

Track different economic sectors on a global,

regional. Or country-specific basis.

Used in cyclical analysis

Can be for a particular country or global.

Style Indices

Measure return to market cap & value, growth
strategies or a combination of these characteristics.

Multiples are used in value & growth indexes

Turnover of style indices is higher than broad market
indices.

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2015, Study Session # 13, Reading # 46

46.i

Different F.I indexes are available to investors.

Several issues with the construction of F.I indexes;

Large universe of securities high turnover in F.I indexes.

Dealer markets & infrequent trading illiquid securities lack of recent trades.

Indexing is difficult for portfolio managers (illiquidity, transaction cost & higher turnover).

Broad market, sector, style & other specialized indices are available.

46.j

Alternative Investments Indices

Commodity Indices

Real Estate Indices

Represent futures contracts on commodities (e.g. grains,

livestock etc).

Issues in commodity indexes;

Variety of weighting schemes (equal, combination of
liquidity measures and world production values etc.)
results in different exposures & risk & return
characteristics.

Based on prices of commodity futures contracts riskfree rate and roll yield and not spot prices of
commodities (return on index differs from return of
commodity itself).

Can be based on property appraisal, repeat

property sales or performance of REITS.

REITS offer good liquidity while constituent
properties are quite illiquid.
Hedge Fund Indices

Equally weight the return of hedge funds included in index.

Performance of different indices can vary substantially (hedge
funds are unregulated).

Upward bias in index return (only successful funds report the
data).

46.k

Index

Reflects

Number of
Constituent
Securities

Weighting Method

Notes

Dow Jones Industrial

Average

Large U.S. stocks

30

Price

Stocks are chosen by Wall Street Journal editors

Nikkei Stock Average

Large Japanese stocks

225

Modified price

Contains some illiquid stocks, price weighting and adjusted for

high-priced shares

TOPIX

All stocks on the Tokyo

Stock Exchange First
Section

Variable

Float-adjusted
market cap

Has a large number of small illiquid stocks making it hard to

replicate. Contains 93% of the market cap of Japanese equities

MSCI All Country World

Index

Stocks in 23 developed
and 22 emerging markets

Variable

Free float-adjusted
market cap

Available in both U.S. dollars and local currency

S&P Developed Ex-U.S.

BMI Energy Sector Index

Global energy stocks

outside the U.S.

Variable

Float-adjusted
market cap

Is the model portfolio for the SPDR S&P Energy-Sector ETF

Barclays Capital Global

Aggregate Bond Index

Global investment-grade
bonds

Variable

Market capitalization

Formerly known as the Lehman Brothers Global Aggregate Bond

Index

Markit iBoxx Euro HighYield Bond Indexes

Below investment-grade
bonds

Variable

Market capitalization
and variations

Represents liquid portion of market and rebalanced monthly

FTSE EPRA/NAREIT Global

Real Estate Index

Global real estate

335

Float-adjusted
market cap

Represents publicly traded REITs

HFRX Global Hedge fund

Index

Global hedge funds

Variable

Asset weighted

Contains a variety of hedge fund strategies and is weighted

based on the amount invested in each hedge fund

HFRX Equal Weighted

Strategies EUR Index

Global hedge funds

Variable

Equal weighted

Contains same strategy funds as HFRX Global Hedge Fund Index

and is denominated in euros

Morningstar Style
Indexes

U.S. stocks grouped by

value/growth and market
cap

Variable

Float-adjusted
market cap

Nine categories classified by combinations of cap categories and

value/growth categories

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