CHAPTER 4

Security Market
Indexes
and Index Funds

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4.1 Uses of Security-Market Indexes
• 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

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4.2 Differentiating Factors in Constructing
Market Indexes
• Three factors are important when constructing
an index intended to represent a total
population:
• The sample
• Weighting sample measures
• Computational procedure

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4.2.1 The Sample
• The Sample
• Size
• Breadth
• Source

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4.2.2 Weighting Sample Members
• Weighting of Sample Members
• Price-weighted index
• Market-value weighted index
• Unweighted (equal-weighted) index
• Fundamental weighted index

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4.2.3 Computational Procedure
• Computational Procedure
• Arithmetic average
• Compute an index and have all changes,
whether in price or value, reported in terms
of the basic index
• Geometric average

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4.3 Stock Market Indexes
• Different indexes experience different
percentage changes

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4.3.1 Price-Weighted Index
• A price-weighted index is an arithmetic mean
of current stock prices, which means that index
movements are influenced by the differential
prices of the components

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4.3.1 Price-Weighted Index (slide 2 of 6)
• Dow Jones Industrial Average
• 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)
• Exhibit 4.1

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4.3.1 Price-Weighted Index (slide 3 of 6)

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4.3.1 Price-Weighted Index (slide 4 of 6)

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4.3.1 Price-Weighted Index (slide 5 of 6)
• Criticism of the DJIA:
• 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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4.3.1 Price-Weighted Index (slide 6 of 6)
• Nikkei-Dow Jones Average
• Arithmetic average of prices for 225 stocks
on the First Section of the Tokyo Stock
Exchange (TSE)
• Price-weighted series
• Criticized because the 225 stocks represent
15 percent of all stocks on the First Section

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4.3.2 Value-Weighted Index
• Derive the initial total market value of all
stocks used in the series
Market Value = Number of Shares Outstanding x Current
Market Price
• Assign an beginning index value (100) and
new market values are compared to the base
index
• Automatic adjustment for stock splits
• Weighting depends on market value
• Exhibit 4.3

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4.3.2 Value-Weighted Index (slide 2 of 4)

where:
Index t = index value on day t
Pt = ending prices for stocks on day t
Qt = number of outstanding shares on day t
Ph = ending price for stocks on base day
Qh = number of outstanding shares on base day

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4.3.2 Value-Weighted Index (slide 3 of 4)

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4.3.2 Value-Weighted Index (slide 4 of 4)

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4.3.3 Unweighted Index
• All stocks carry equal weight regardless of
price or market value
• May be used by individuals who randomly
select stocks and invest the same dollar
amount in each stock
• Some use arithmetic average of the percent
price changes for the stocks in the index
• Value Line and the Financial Times Ordinary
Share Index compute a geometric mean of the
holding period returns
• See Exhibits 4.5, 4.6

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4.3.3 Unweighted Index (slide 2 of 3)

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4.3.3 Unweighted Index (slide 3 of 3)

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4.3.4 Fundamental Weighted Index
• Rationale
• Market-value weighting scheme results in
overweighting overvalued stocks and
underweighting undervalued stocks over time
• The tech boom in 1998–2000 was a good
example
• Fundamental measures of firm size
• Sales
• Profits (cash flow)
• Net asset (book value)
• Distributions to shareholders (dividends)

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4.3.5 Style Indexes
• Small-cap growth
• Mid-cap growth
• Large-cap growth
• Small-cap value
• Mid-cap value
• Large-cap value
• Socially responsible investment (SRI) indexes
• By country
• Global ethical stock index

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4.3.5 Style Indexes (slide 2 of 2)

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4.3.6 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
computational procedure
• Groups have computed country indexes
• Exhibits 4.8, 4.9

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4.3.6 Global Equity Indexes (slide 2 of 10)

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4.3.6 Global Equity Indexes (slide 3 of 10)

• FT/S&P-Actuaries World Indexes

• 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 percent of the total value of all listed
companies in each country
• Includes actively traded medium and small
corporations along with major international equities
• Securities included must allow direct holdings of
shares by foreign nationals
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4.3.6 Global Equity Indexes (slide 4 of 10)

• FT/S&P-Actuaries World Indexes

• Index is market-value weighted with a base
date of December 31, 1986 = 100
• 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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4.3.6 Global Equity Indexes (slide 5 of 10)

• Morgan Stanley Capital International (MSCI)

Indexes
• Three international, 19 national, and 38
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

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4.3.6 Global Equity Indexes (slide 6 of 10)

• Morgan Stanley Capital International (MSCI)

Indexes
• Also provides
▪ price to book value (P/BV) ratio
▪ price to cash earnings (earnings plus depreciation)
(P/CE) ratio
▪ 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
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4.3.6 Global Equity Indexes (slide 7 of 10)

• Dow Jones Global Stock Market Indexes

• 2,200 companies worldwide
• Organized into 120 industry groups
• Includes 33 countries representing more than
80 percent of the combined capitalization of
these countries
• 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
• Exhibit 4.9

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4.3.6 Global Equity Indexes (slide 8 of 10)

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4.3.6 Global Equity Indexes (slide 9 of 10)

• 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
• See Exhibit 4.10

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4.3.6 Global Equity Indexes (slide 10 of 10)

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4.4 Bond-Market Indexes
• 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
▪ Exhibit 4.11

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4.4 Bond-Market Indexes (slide 2 of 3)

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4.4 Bond-Market Indexes (slide 3 of 3)
• Difficulties in creating a 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 problems

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4.4.1 U.S. Investment-Grade Bond Indexes

• Four investment firms maintain indexes for

Treasury bonds and other investment grade
(rated BBB or Baa or higher) bonds
• Relationship among these bonds is strong
(correlations average 0.95)
• Returns for all these bonds are driven by
aggregate interest rates—shifts in the
government yield curve

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4.4.2 High-Yield Bond Indexes
• Non-investment-grade bonds
• Rated Ba, B, Caa, Ca, and C
• Four investment firms and two academicians
created indexes
• Relationship among alternative high-yield
bond indexes is weaker than among
investment grade indexes

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4.4.3 Global Government Bond Indexes
• Global bond market dominated by government
(sovereign) issues
• Several indexes created by major investment
firms
▪ Sample sizes and numbers of countries differ
• Exhibit 4.12

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4.4.3 Global Government Bond Indexes (slide 2
of 2)

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4.5 Composite Stock-Bond Indexes
• 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

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4.5 Composite Stock-Bond Indexes (slide 2 of
4)
• 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

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4.5 Composite Stock-Bond Indexes (slide 3 of
4)
• 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
• Close to the theoretical “market portfolio of risky
assets” referred to in the CAPM literature

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4.5 Composite Stock-Bond Indexes (slide 4 of
4)
Brinson Partners Global Security Market Index (GSMI) as of July
2017:

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4.6 Comparison of Indexes Over Time
• Price movements in the different indexes for
monthly intervals
• Exhibit 4.13

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4.6 Comparison of Indexes Over Time (slide
2 of 2)

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4.6.2 Correlations between Monthly Bond Index
Returns
• Correlations with:
• U.S. investment grade bond indexes is about 0.93,
which confirms that the overriding determinate of rates
of return for investment-grade bonds over time are
Treasury interest rates
• High-yield bonds indicate a significantly weaker
relationship (correlations about 0.51) caused by the
strong equity characteristics of high-yield bonds
• Among U.S. investment-grade bonds and all world
government bonds (0.58) and world government
bonds without the United States (about 0.36) reflect
different interest rate movements and exchange rate
effects

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4.7 Investing in Security Market Indexes
• The two most significant uses for security market series are:
• As a benchmark to measure the performance by portfolio
managers
• To create index funds and/or exchange traded funds (ETFs)
• Closely related because when professional institutions
measured performance using these market series they
discovered that the vast majority of money managers could
not match the risk-adjusted performance of the benchmarks
• The results of these studies led to the conclusion
(recommendation) that many investors should not attempt to
beat the market (the market series) by engaging in active
portfolio management that attempts to “beat the market” over
time by selecting undervalued stocks

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4.7 Investing in Security Market Indexes
(slide 2 of 5)
• Index Funds
• For an indexed portfolio, the fund manager will typically attempt to
replicate the composition of the particular index exactly
• He or she will buy the exact securities comprising the index in their exact
weights and then alter those positions anytime the index composition is
changed
• Because changes to most equity indexes occur sporadically, index funds
tend to generate low trading and management expense ratios
• Advantage of index mutual funds
• They provide an inexpensive way for investors to acquire a diversified portfolio
that emphasizes the desired market or industry within the context of a traditional
money management product
• Disadvantages of mutual funds
• Investors can only liquidate their positions at the end of the trading day usually
cannot short sell and may have unwanted tax repercussions if the fund sells a
portion of its holdings, thereby realizing capital gains
• Exhibit 4.14

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4.7 Investing in Security Market Indexes
(slide 3 of 5)

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4.7 Investing in Security Market Indexes
(slide 4 of 5)
• Exchange-Traded Funds
• ETFs are depository receipts that give investors a pro rata
claim on the capital gains and cash flows of the securities
that are held in deposit by the financial institution that
issued the certificates
• A portfolio of securities is placed on deposit at a financial
institution, which then issues a single type of certificate
representing ownership of the underlying portfolio
• Notable example of ETFs:
• Standard & Poor’s 500 Depository Receipts (SPDRs)
• iShares, which recreate indexed positions in several global
developed and emerging equity markets
• Sector ETFs, which invest in baskets of stocks from specific
industry sectors
• Exhibit 4.15

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4.7 Investing in Security Market Indexes
(slide 5 of 5)

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Appendix Chapter 4

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Appendix Chapter 4 (slide 2 of 4)

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Appendix Chapter 4 (slide 3 of 4)

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Appendix Chapter 4 (slide 4 of 4)

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