A
stock market index is a method of measuring a
section of the
stock market. Many
indices are cited by news or financial services firms and are used
to benchmark the performance of portfolios such as
mutual funds.
Types of indices
Stock market indices may be classed in many ways. A 'world' or
'global' stock market index includes (typically large) companies
without regard for where they are domiciled or traded. Two examples
are
MSCI World and
S&P Global 100.
A
national index represents the performance of the stock
market of a given nation—and by proxy, reflects investor sentiment
on the state of its economy. The most regularly quoted market
indices are national indices composed of the stocks of large
companies listed on a nation's largest stock exchanges, such as the
American
S&P 500, the Japanese
Nikkei 225, and the British
FTSE 100.
The concept may be extended well beyond an exchange.
The Dow Jones Total
Stock Market Index, as its name implies, represents the stocks of
nearly every publicly traded company in the United States
, including all U.S. stocks traded on the New York Stock
Exchange
(but not ADR) and most traded on the
NASDAQ and American Stock Exchange
. Russell
Investment Group added to the family of indices by launching
the
Russell Global Index.
More specialised indices exist tracking the performance of specific
sectors of the market.
The Morgan Stanley Biotech Index,
for example, consists of 36 American firms in the
biotechnology industry. Other
indices may track companies of a certain size, a certain type of
management, or even more specialized criteria — one index published
by
Linux Weekly News tracks stocks
of companies that sell products and services based on the
Linux operating environment.
Index versions
Some indices, such as the
S&P 500,
have multiple versions. These versions can differ based on how the
index components are weighted and on how
dividends are accounted for. For example, there are
three versions of the
S&P 500 index:
price return, which only considers the price of the components,
total return, which accounts for dividend reinvestment, and net
total return, which accounts for dividend reinvestment after the
deduction of a withholding tax. As another example, the
Wilshire 4500 and
Wilshire 5000 indices have five versions each:
full capitalization total return, full capitalization price,
float-adjusted total return, float-adjusted price, and equal
weight. The difference between the full capitalization,
float-adjusted, and equal weight versions is in how index
components are weighted.
Weighting
An index may also be classified according to the method used to
determine its price. In a
Price-weighted index such as the
Dow Jones Industrial
Average,
Amex Major Market
Index, and the
NYSE ARCA
Tech 100 Index, the price of each component stock is the only
consideration when determining the value of the index. Thus, price
movement of even a single security will heavily influence the value
of the index even though the dollar shift is less significant in a
relatively highly valued issue, and moreover ignoring the relative
size of the company as a whole. In contrast, a
market-value weighted or
capitalization-weighted index
such as the
Hang Seng Index factors
in the size of the company. Thus, a relatively small shift in the
price of a large company will heavily influence the value of the
index. In a
market-share
weighted index, price is weighted relative to the number
of shares, rather than their total value.
Traditionally, capitalization- or share-weighted indices all had a
full weighting i.e. all outstanding shares were included.
Recently, many of them have changed to a
float-adjusted weighting which helps
indexing.
A
modified market cap
weighted index is a hybrid between equal weighting and
capitalization weighting. It is similar to a general market cap
with one main difference: the largest stocks are capped to a
percent of the weight of the total stock index and the excess
weight will be redistributed equally amongst the stocks under that
cap. Moreover, in 2005, Standard & Poor's introduced the
S&P Pure Growth Style Index and S&P Pure Value Style Index
which was
attribute weighted.
That is, a stock's weight in the index is decided by the score it
gets relative to the value attributes that define the criteria of a
specific index, the same measure used to select the stocks in the
first place. For these two stocks, a score is calculated for every
stock, be it their growth score or the value score (a stock cant be
both) and accordingly they are weighted for the index .
Criticism of capitalization-weighting
The use of capitalization-weighted indices is often justified by
the central conclusion of
modern
portfolio theory that the optimal investment strategy for any
investor is to hold the market portfolio, the
capitalization-weighted portfolio of all assets. However, empirical
tests conclude that market indices are not efficient. This can be
explained by the fact that these indices do not include all assets
or by the fact that the theory does not hold. The practical
conclusion is that using capitalization-weighted portfolios is not
necessarily the optimal method.
As a consequence, capitalization weighting has been subject to
severe criticism (see e.g. Haugen and Baker 1991, Amenc, Goltz, and
Le Sourd 2006, or Hsu 2006), pointing out that the mechanics of
capitalization weighting lead to trend-following strategies that
provide an inefficient risk-return trade-off.
Also, while capitalization weighting is the standard in equity
index construction, different weighting schemes exist. First, while
most indices use capitalization weighting, additional criteria are
often taken into account, such as sales/revenue and net income (see
the “Guide to the Dow Jones Global Titan 50 Index”, January 2006).
Second, as an answer to the critiques of capitalization-weighting,
equity indices with different weighting schemes have emerged, such
as "wealth"-weighted (Morris, 1996),
“fundamental”-weighted (
Arnott, Hsu and Moore 2005),
“diversity”-weighted (Fernholz, Garvy, and Hannon 1998) or
equal-weighted indices.
Indices and passive investment management
There has been an accelerating trend in recent decades to create
passively managed mutual funds that are based on market indices,
known as
index funds. Advocates claim
that index funds routinely beat a large majority of
actively managed mutual funds; one study
claimed that over time, the average actively managed fund has
returned 1.8% less than the
S&P 500
index - a result nearly equal to the average expense ratio of
mutual funds (fund expenses are a drag on the funds' return by
exactly that ratio). Since index funds attempt to replicate the
holdings of an index, they obviate the need for — and thus many
costs of — the research entailed in active management, and have a
lower "churn" rate (the turnover of securities which lose fund
managers' favor and are sold, with the attendant cost of
commissions and capital gains taxes).
Indices are also a common basis for a related type of investment,
the
exchange-traded fund or
ETF. Unlike an index fund, which is priced daily, an ETF is priced
continuously, is optionable, and can be sold short.
Dr. Emanuele Canegrati of
Catholic University of Milan
has recently developed the concept of
Market Index Leader. Based on the
Granger causality concept, he
defined a market index leader one which Granger-causes other
indices and it is not Granger-caused by any other index . Since
Granger-causality does not deal with "true"
causality, but only with a temporal sequence of
events which have a linkage, he discovered that some indices are
first-movers (leaders) and some others
follow them. The former Granger-cause the latter.
Ethical stock market indices
A notable specialised index type is those for
ethical investing indices that include
only those companies satisfying ecological or social criteria, e.g.
those of
The Calvert Group,
KLD,
FTSE4Good Index,
Dow Jones Sustainability
Index and
Wilderhill
Clean Energy Index.
Another important trend is strict mechanical criteria for inclusion
and exclusion to prevent market manipulation, e.g. in Canada when
Nortel was permitted to rise to over 30% of
the
TSE 300 index value. Ethical
indices have a particular interest in mechanical criteria, seeking
to avoid accusations of ideological bias in selection, and have
pioneered techniques for inclusion and exclusion of stocks based on
complex criteria. Another means of mechanical selection is
mark-to-future methods that exploit
scenarios produced by multiple analysts weighted according to
probability, to determine which stocks have become too risky to
hold in the index of concern.
Critics of such initiatives argue that many firms satisfy
mechanical "ethical criteria", e.g. regarding board composition or
hiring practices, but fail to perform ethically with respect to
shareholders, e.g.
Enron. Indeed, the seeming
"seal of approval" of an ethical index may put investors more at
ease, enabling scams. One response to these criticisms is that
trust in the corporate management, index criteria, fund or index
manager, and securities regulator, can never be replaced by
mechanical means, so "
market
transparency" and "
disclosure" are
the only long-term-effective paths to fair markets.
Environmental stock market indices
An environmental stock market index aims to provide a quantitative
measure of the environmental damage caused by the companies in an
index. Indices of this nature face much of the same criticism as
Ethical indices do — that the 'score' given is partially
subjective.
However, whereas 'ethical' issues (for example, does a company use
a
sweatshop) are largely subjective and
difficult to score, an environmental impact is often quantifiable
through scientific methods. So it is broadly possible to assign a
'score' to (say) the damage caused by a tonne of
mercury dumped into a local river. It is
harder to develop a scoring method that can compare different types
of pollutant — for example does one hundred tonnes of
carbon dioxide emitted to the air cause more
or less damage (via
climate change)
than one tonne of mercury dumped in a river (and poisoning all the
fish).
Generally, most environmental economists attempting to create an
environmental index would attempt to quantify damage in monetary
terms. So one tonne of carbon dioxide might cause $100 worth of
damage, whereas one tonne of mercury might cause $50,000 (as it is
highly toxic). Companies can therefore be given an 'environmental
impact' score, based on the cost they impose on the environment.
Quantification of damage in this nature is extremely difficult, as
pollutants tend to be market
externalities and so have no easily measurable
cost by definition.
Innovations Awards to Stock Indices
The
William F. Sharpe Indexing Achievement Awards are presented
annually in order to recognize the most important contributions to
the indexing industry over the preceding year.
- Most Innovative Benchmark Index
- Most Innovative ETF
- 2004 — iShares MSCI
EAFE (EFA) and Emerging Markets
- 2005 — EasyETF GSCI Commodities ETF
- 2006 — PowerShares DB Commodity Index Tracking Fund (DBC) and
PowerShares G10 Currency Harvest Fund (DBV)
- 2007 - SPDR DJ Wilshire International Real Estate ETF
- Most Innovative Index Product
- Best Index-related Research Paper
- Lifetime Achievement Award
Lists
See also
References
- Amenc, N., F. Goltz, and V. Le Sourd, 2006, “Assessing the
Quality of Stock Market Indices”, EDHEC Publication
- Arnott, R.D., J. Hsu, and P. Moore, 2005, “Fundamental
Indexation”, Financial Analysts Journal 60(2), 83–99.
- Broby, D.P., 2007 "A Guide to Equity Index Construction", Risk
Books.
- Fernholz, R., R. Garvy, and J. Hannon, 1998,
“Diversity-Weighted Indexing”, Journal of Portfolio Management,
24(2), 74–82
- Haugen, R.A., and N.L. Baker, 1991, “The Efficient Market
Inefficiency of Capitalization-Weighted Stock Portfolios”, Journal
of Portfolio Management
- Hsu, Jason, 2006, “Cap-Weighted Portfolios are Sub-optimal
Portfolios”, Journal of Investment Management, 4(3), 1–10
External links
Wikis
Quiz
Map
Search
