CHAPTER ELEVEN MARKET INDEXES Practical Investment Management Robert A. Strong

South-Western College Publishing © Outline  Index Construction  Price Weighting  Equal Weighting  Capitalization Weighting  Popular Indexes  Stock Indexes  Fixed Income Indexes  International Indexes

South-Western College Publishing © Index Construction: Price Weighting  A price-weighted index is composed of a single share of each of the index components, regardless of the price of the share or the size of the underlying company.  For example, the shares of 30 industrial companies make up the Dow Jones Industrial Average (DJIA).  To account for artificial price changes due to stock splits, an index divisor is made use of.

New Divisor after a Stock Split Divisor /3.0 = $20 $40/2.0 = $20 Apparent change = 0.0% The divisor maintains economic integrity. South-Western College Publishing © Day One Day Two Company A $30 3-for-1 split $10 Company B Company C Total $60 $40 Apparent change in index = %

South-Western College Publishing © Index Construction: Equal Weighting  An equal-weighted index reflects the performance associated with the selection of a particular security by chance. It is measured by price change rather than by price alone.  Theoretically, equal weighting is preferable to price weighting.

South-Western College Publishing © Initial Subsequent Weighted Security Price Price Return Return A $ 10 $ % 1.00 % B C D E Index % Construction of an Equal-Weighted Index

South-Western College Publishing © Index Construction: Capitalization Weighting  In capitalization weighting, also called value weighting, the share price is multiplied by the number of outstanding shares.  The total is then compared to some arbitrary starting value (base value).

Construction of a Value-Weighted Index Company Shares Outstanding Price Shares x Price A 200,000,000 $30 $6,000,000,000 B 50,000, ,000,000,000 C 100,000, ,000,000,000 Base Value  $8,000,000,000 Initial value of the index = = $8,000,000,000 $80,000,000 Suppose that later, shares x price sum up to $8,200,000,000. Then the new value of the index = = $8,200,000,000 $80,000,000 South-Western College Publishing ©1998 8

9 Popular Indexes: Stock Indexes  The four primary averages are the industrial average (30 large blue chip companies), the transportation average (20 transportation companies), the utility average (15 public utility stocks), and the Dow Jones composite (all the 65 stocks in the DJIA, DJTA, and DJUA).  Price-weighted. Dow Jones Averages

South-Western College Publishing © Popular Indexes: Stock Indexes  The main indexes are the S&P 500 Composite (500 NYSE-traded securities), S&P Mid Cap 400 (400 mid-capitalization securities), S&P Small Cap 600 (600 small-cap stocks), and the S&P Super Composite 1500 ( ).  Value-weighted. Standard & Poor’s Indexes

South-Western College Publishing © Popular Indexes: Stock Indexes  The NYSE Composite is an average of all the stocks listed on the New York Stock Exchange.  The Russell 3000 index is a mix of both large- and small-capitalization stocks and, to many portfolio managers, a better representation of the broad market. Others

South-Western College Publishing © Popular Indexes: Fixed Income Indexes  More than 400 indexes measure fixed income securities.  Examples include : - Dow Jones 20 Bond Index - S&P Municipal Bond Index - S&P U.S. Government Bond Index - Salomon Brothers Corporate Bond Index

South-Western College Publishing © Popular Indexes: International Indexes  European indexes - United Kingdom: FT-SE Germany: DAX 30 - France: CAC-40 - Italy: MIB 30  Asia and the Pacific Rim - Japan: Nikkei 225, TOPIX, Nikkei Australia: All Ordinaries - Hong Kong: Hang Seng

South-Western College Publishing © Review  Index Construction  Price Weighting  Equal Weighting  Capitalization Weighting  Popular Indexes  Stock Indexes  Fixed Income Indexes  International Indexes