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Chapter 7

Chapter 7. SECURITY-MARKET INDEXES. Chapter 7 Questions. What are some major uses of security-market indexes? What are the major characteristics that cause various indexes to differ?

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Chapter 7

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  1. Chapter 7 SECURITY-MARKET INDEXES

  2. Chapter 7 Questions • What are some major uses of security-market indexes? • What are the major characteristics that cause various indexes to differ? • What are the major stock-market indexes in the United States and globally, and what are their characteristics? • What are the major bond-market indexes for the United States and the world?

  3. Chapter 7 Questions • Why are bond indexes more difficult to create and maintain than stock indexes? • What are some of the composite stock-bond market indexes? • Where can you get historical and current data for all these indexes? • What is the relationship among many of these indexes in the short-run (monthly)?

  4. What is a market index? It is an indicator that answers the question: What happened in the market today?

  5. Uses of Security-Market Indexes • For calculating benchmark returns to judge portfolio performance • For development of an index portfolio • For examining factors that influence aggregate security price movements • For technical analysis, to predict future price movements • To compute a security’s systematic risk by examining how its return responds to changes in the market index

  6. Factors in Constructing Market Indexes • The sample of firms to include • What is the intended population that the sample is to represent? How large a sample is needed for the index to be representative? • Weighting system for sample members • Should the weighting system be based on price, total firm value, or equally weighted? • Computational procedure • How should the values of the index be reported and tracked (arithmetic or geometric mean)?

  7. Stock-Market Indexes • Price-Weighted Indexes • Dow Jones Industrial Average (DJIA) • Value-Weighted Indexes • NYSE Composite • S&P 500 Index • Russell Indexes • Willshire 5000 Index • Equal-Weighted Indexes • Value Line Averages

  8. Dow Jones Industrial Average (DJIA) • 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 by a divisor • Original divisor was 30 • Divisor now adjusted for stock splits and changes in the sample, so now much smaller (about 0.1356 in October 2004)

  9. Criticism of the DJIA • Sample used is limited • 30 non-randomly selected blue-chip stocks are not representative of the 1800 NYSE listed stocks • Price-weighted series • Similar to assuming an investment of one share per stock • Places more weight on higher-priced stocks rather than those with higher market values • Introduces a downward bias in DJIA by reducing weight of growing companies whose stock splits

  10. Value-Weighted Indexes • Although the DJIA is the most popular index, the most popular type is value-weighted. • Derive the initial total market value of all stocks used in the series Market Value = Number of Shares Outstanding x Current Market Price • Beginning index value is usually 100, new market values change the value of the index • Automatic adjustment for splits • Weighting depends on market value

  11. Value-Weighted Indexes where: Indext = index value on day t Pt = ending prices for stocks on day t Qt = number of outstanding shares on day t Pb = ending price for stocks on base day Qb = number of outstanding shares on base day

  12. Value-Weighted Indexes • Construction similar to assuming investment in proportion to total market value • Take into account that large market value stocks make up more of the market than do smaller market value stocks • Large market value stocks dominate the impact on index values over time • Also these series tend to be more broad than the DJIA

  13. Unweighted Price Indexes • All stocks carry equal weight regardless of price or market value • Constructed in a parallel fashion to individuals who select stocks and invest the same dollar amount in each stock • Changes in the index can be reported either in terms of arithmetic or geometric means

  14. Style Indexes • Additional indexes have been created that seek to measure the performance of various investment styles or sectors • Size indexes track the performance of large-cap, mid-cap, and small cap stocks • Other indexes track the relative performance of growth and value stocks, perhaps also broken down into sizes

  15. Global Equity Indexes • 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 computation • In response, some standardized indexes have been developed • FT/S&P Actuaries World Indexes • Morgan Stanley Capital International (MSCI) World Indexes • Dow Jones World Stock Index

  16. FT/S&P-Actuaries World Indexes • Track over 2,400 securities in 30 countries • Covers 70% of the total value of all listed companies in each country • Securities included must allow direct holdings of shares by foreign nationals • Index is market-value weighted with a base date of December 31, 1986 = 100 • Results are calculated daily and published the following day in the Financial Times • Geographic subgroups are also published

  17. MSCI Indexes • Three international, nineteen national, and thirty-eight international industry indexes • Include 1,673 companies listed on stock exchanges in 19 countries with a combined capitalization representing 60 percent of the aggregate market value of the stock exchanges of these countries • All the indexes are market-value weighted

  18. Dow Jones World Stock Index • Introduced in January 1993 • Includes 28 countries with a total of 2,200 companies worldwide, organized into 120 industry groups • Countries are grouped into 3 regions • Represents over 80% of the combined capitalization of these countries

  19. Comparison of World Stock Indexes • Correlations between all of the pairs of broad world indexes are nearly 1.00, indicating that the results with the alternative world stock indexes are quite comparable

  20. Bond-Market Indexes • Relatively new and not widely published • Growth in fixed-income mutual funds increase need for reliable benchmarks for evaluating performance • Increasing interest in bond index funds, which requires an index to emulate • Many managers have not matched aggregate bond market return

  21. Difficulties in Creating a Bond-Market Index • 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 differently by changing interest rates dependent on maturity, coupon, and market yield • Correctly pricing individual bond issues can be a challenge without current and continuous transaction prices available

  22. Bond Market Indexes • Investment-Grade Bond Indexes • Four investment firms maintain indexes for Treasury bonds and other investment grade bonds (rated BBB or higher) • Relationship among these bonds is strong (correlations average 0.95) • High-Yield Bond Indexes • Non investment-grade bonds (rated BB or below) • Several indexes have been created • Relationship among alternative high-yield indexes is weaker than among investment grade indexes

  23. Bond Market Indexes • Global Government Bond Market Indexes • Global bond market dominated by government issues • Several indexes created by major investment firms • Indexes have similar characteristics

  24. Composite Stock-Bond Indexes Considers the benefits of diversification with asset allocation across stocks and bonds • 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 • Brinson Partners Global Security Market Index (GSMI) • Matches a typical U.S. pension fund allocation policy • Close to the theoretical “market portfolio of risky assets” referred to in CAPM

  25. Comparison of Indexes Over Time • Correlations among monthly equity price changes • Most differences are attributable to sample differences • High correlations between S&P 500 and several broad stock market indexes (.98-.99) • Lower correlations between style indexes and other broader indexes • Correlations between U.S. series and other countries confirm the wisdom of global investing since values are often much lower

  26. Comparison of Indexes Over Time • Correlations among monthly bond indexes • Among investment-grade bonds correlations range from 0.94 to 0.98 • Significantly lower correlation between investment grade and high-yield indexes (about 0.49) • Low correlation in global returns to U.S. returns (about 0.35) support global diversification

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