Security Market Indices

By the end of this chapter students must:

1. Demonstrate an understanding of the construction, calculation, and weaknesses of
price-weighted, market capitalisation-weighted, and equal-weighted indexes.
2. Be familiar with the various security indexes and their potential weaknesses

Description/Characterisation of Security Market Indices

 A security market index is used to represent the performance of an asset class,
security market, or segment of a market.
 They are usually created as portfolios of individual securities, which are referred to as
the constituent securities of the index.
 An index has a numerical value that is calculated from the market prices (actual when
available, or estimated) of its constituent securities at a point in time.
 An index return is the percentage change in the index's value over some time.

Issues in Index Construction and Management

Index providers must make several decisions:
 What is the target market the index is intended to measure?
 Which securities from the target market should be included?
 How should the securities be weighted in the index?
 How often should the index be rebalanced?
 When should the selection and weighting of securities be re-examined?
The target market may be defined very broadly (e.g., stocks in Zimbabwe) or narrowly (e.g.,
ZSE top 10). It may also be defined by geographic region or by economic sector (e.g.,
financials stocks). The constituent stocks in the index could be all the stocks in that market or
just a representative sample. The selection process may be determined by an objective rule or
subjectively by a committee.

Weighting Methods in Index Construction

For stock indexes the weighting methods include
1. price weighting,
2. equal weighting,
3. market capitalization weighting,
4. float-adjusted market capitalization weighting, and
5. fundamental weighting
Price Weighted Index
 A price-weighted index is an arithmetic average of the prices of the securities
included in the index.
 The divisor of a price-weighted index is adjusted for stock splits and changes in the
composition of the index when securities are added or deleted, such that the index
value is unaffected by such changes.
Advantages
 Computation is simple.
Disadvantage
 Percentage change in the price of a higher priced stock has a greater impact on the
index's value than does an equal percentage change in the price of a lower priced
stock. Thus, higher priced stocks have more weight in the calculation of a price-
weighted index.
Two major price-weighted indexes are the Dow Jones Industrial Average (DJIA) and the
Nikkei Dow Jones Stock Average. The DJIA is a price-weighted index based on 30 U.S.
stocks. The Nikkei Dow is constructed from the prices of 225 stocks that trade in the first
section of the Tokyo Stock Exchange.
Formula

Example:

Suppose at the market close on day 1, Delta has a price of $10, Econet has a price of $20, and
Cafca has a price of $90.
The value of a price-weighted index of these three stocks is (10 + 20 + 90) / 3 = 40 at the
close of trading.
If Cafca splits 2-for-1, effective on day 2, what is the new denominator for the index?
Answer:
The effect of the split on the price Cafca, in the absence of any change from the price at the
end of day 1, would be to reduce it to $90 / 2 = $45. The index denominator will be adjusted
so that the index value would remain at 40 if there were no changes in the stock prices other
than to adjust for the split.
The new denominator, d, must satisfy (10 + 20 + 45) / d = 40 and equals 1.875.

Equal-weighted index
 Is calculated as the arithmetic average return of the index stocks.
Advantage
 Simplicity of computations
Disadvantage
 A matching portfolio would have to be adjusted periodically (rebalanced) as prices
change so that the values of all security positions are made equal each period.
 The portfolio rebalancing required to match the performance of an equal-weighted
index creates high transactions costs that would decrease portfolio returns.
 The weights placed on the returns of the securities of smaller capitalisation firms are
greater than their proportions of the overall market value of the index stocks.
Conversely, the weights on the returns of large capitalisation firms in the index are
smaller than their proportions of the overall market value of the index stocks.
Examples of equally weighted index returns include the Value Line Composite Average and
the Financial Times Ordinary Share Index.

Market capitalization-weighted index

 Weights based on the market capitalization of each index stock.
 A market capitalization-weighted index return can be matched with a portfolio in
which the value of each security position in the portfolio is the same proportion of the
total portfolio value as the proportion of that security's market capitalization to the
total market capitalization of all of the securities included in the index.
 This weighting method more closely represents changes in aggregate investor wealth
than price weighting.
 Because the weight of an index stock is based on its market capitalization, a market
capitalization-weighted index does not need to be adjusted when a stock splits or pays
a stock dividend.
 An alternative to using a firm's market capitalization to calculate its weight in an
index is to use its market float - the total value of the shares that are actually available
to the investing public and excludes the value of shares held by controlling
stockholders because they are unlikely to sell their shares.
 For example, the float for Econet would exclude shares owned by Strive Masiyiwa
(and other large shareholders such as corporations or governments).
 Sometimes the market float calculation excludes shares that are not available to
foreign buyers and is then referred to as the free float. The reason for this is to better
match the index weights of stocks to their proportions of the total value of all the
shares of index stocks that are actually available to investors.
Formula

Example: Price-weighted vs. market capitalization-weighted indexes

Consider the three firms described below. Compare the effects on a price-weighted
index and a market capitalization-weighted index if Stock A doubles in price or if
Stock C doubles in price. Assume the period shown in the table is the base period for
the market capitalization-weighted index and that its base value is 100.
Index Firm Data

Company Number of Shares Stock Price Capitalization

Outstanding (000s) (000s)

A 100 100 10000

B 1000 10 10000
C 20000 1 20000

Answer:
The price-weighted index equals:

If Stock A doubles in price to $200, the price-weighted index value is:

If Stock C doubles in price to $2, the price-weighted index value is:

If Stock A doubles in value, the index goes up 33.33 points, while if Stock C doubles in
value, the index only goes up 0.33 points. Changes in the value of the firm with the highest
stock price have a disproportionately large influence on a price-weighted index.
For a market capitalization-weighted index, the base period market capitalization is
(100,000 X $100) + (1,000,000 X $10) + (20,000,000 X $1) = $40,000,000.
If Stock A doubles in price to $200, the index goes to:

If Stock C doubles in price to $2, the index goes to:

In the market capitalization-weighted index, the returns on Stock C have the greatest
influence on the index return because Stock C's market capitalization is larger than that of
Stock A or Stock B.

Float-adjusted market capitalization-weighted index

 is constructed just like a market capitalization-weighted index, however the weights,
are based on the proportionate value of each firm's shares that are available to
investors to the total market value of the shares of index stocks that are available to
investors.
 Firms with relatively large percentages of their shares held by controlling stockholders
will have less weight than they have in an unadjusted market-capitalization index.
Advantage
 For both market capitalization-weighted indexes, the security weights represent
proportions of total market value.
Disadvantage
 The relative impact of a stock's return on the index increases as its price rises and
decreases as its price falls. Thus, overvalued stocks are given disproportionately high
weights in the index while the undervalued stocks are given disproportionately low
weights.
 Holding a value weighted portfolio is, therefore, similar to following a momentum
strategy, under which the most successful stocks are given the greatest weights and
poor performing stocks are underweighted.

The Standard and Poor's 500 (S&P 500) Index is an example of a market capitalization-
weighted index.

Fundamental weighting index

 Uses weights based on firm fundamentals, such as earnings, dividends, or cash flow.
 Fundamental weights can be based on a single measure or some combination of
fundamental measures.
Advantage
 It avoids the bias of market capitalization-weighted indexes toward the performance of
the shares of overvalued firms and away from the performance of the shares of
undervalued firms.
 A fundamental weighted index will actually have a value tilt, overweighting firms with
high value-based metrics such as book-to-market ratios or earnings yields.

Rebalancing of an index.
Rebalancing refers to adjusting the weights of securities in a portfolio to their target weights
after price changes have affected the weights. For index calculations, rebalancing to target
weights on the index securities is done on a periodic basis, usually quarterly. Because the
weights in price- and value-weighted indexes (portfolios) are adjusted to their correct values
by changes in prices, rebalancing is an issue primarily for equal weighted indexes. As noted
previously, the weights on security returns in an (initially) equal-weighted portfolio are not
equal as securities prices change over time. Therefore, rebalancing the portfolio at the end of
each period used to calculate index returns is necessary for the portfolio return to match the
index return.
Reconstitution of an index
Index reconstitution refers to periodically adding and deleting securities that make up an
index. Securities are deleted if they no longer meet the index criteria and are replaced by
other securities that do. Indexes are reconstituted to reflect corporate events such as
bankruptcy or delisting of index firms and are at the subjective judgment of a committee.
When a security is added to an index, its price tends to rise as portfolio managers seeking to
track that index in a portfolio buy the security. The prices of deleted securities tend to fall as
portfolio managers sell them. Note that additions and deletions also require that the weights
on the returns of other index stocks be adjusted to conform to the desired weighting scheme.

Commodity indexes
Represent futures contracts on commodities such as grains, livestock, metals, and energy.
Examples include the Commodity Research Bureau Index and the S&P GSCI (previously the
Goldman Sachs Commodity Index).
The issues in commodity indexes relevant for investors are as follows:
 Weighting method. Commodity index providers use a variety of weighting schemes.
Some use equal weighting, others weight commodities by their global production
values, and others use fixed weights that the index provider determines. As a result,
different indexes have significantly different commodity exposures and risk and
return characteristics. For example, one index may have a large exposure to the prices
of energy commodities while another has a large exposure to the prices of agricultural
products.
 Futures vs. actual. Commodity indexes are based on the prices of commodity futures
contracts, not the spot prices of commodities. Commodity futures contracts reflect the
risk-free rate of return, changes in futures prices, and the roll yield. Furthermore, the
contracts mature and must be replaced over time by other contracts. For these reasons,
the return on commodity futures differs from the returns on a long position in the
commodity itself.

Real estate indexes
Can be constructed using returns based on appraisals of properties, repeat property sales, or
the performance of Real Estate Investment Trusts (REITs). REITs are similar to closed-end
mutual funds in that they invest in properties or mortgages and then issue ownership interests
in the pool of assets to investors. While real properties are quite illiquid, REIT shares trade
like any common shares and many offer very good liquidity to investors. FTSE International
produces a family of REIT indexes.