Market Indexes-Investment Managment And Portfolio-Lecture Notes, Study notes of Investment Management and Portfolio Theory

Download Market Indexes-Investment Managment And Portfolio-Lecture Notes and more Study notes Investment Management and Portfolio Theory in PDF only on Docsity! y g ( ) Lesson # 25 MARKET INDEXES Introduction: Indexes are useful in assessing investment results. They provide a benchmark against which performance can be compared. They also useful in financial research, through which an investigator seeks to discover the relationship between certain economic variables and market results. In fact, most of us keep abreast of developments in “the market” by watching the indexes. Because television or radio announcers cannot possibly cover price changes for every security, they quote the value of some well-known market measure, such as the Dow Jones Industrial Average. On-the-hour radio news frequently concludes with a statement such as “On Wall Street, the Dow Jones Industrial Average is up 123 points on volume of 630 million shares.” To investors everywhere, this news is an indicator of the day’s market activity and a good clue as to what is happening with their own favorite securities. This chapter provides an overview of some of the most popular indexes. Index Construction: Indexes can be useful in following investment performance, but only if an investor knows what the index is measuring and how similar the index is to a particular investment portfolio. Knowing that the general level of bond prices in Singapore declined today may not tell investors much about how U.S computer stock fared. Price Weighting: A price-weighted index is composed of a single share of each of the index component, regardless of the price of the share or the size of the underlying company: the Dow Jones Industrial Average (DJIA) is an example of such an index. The first step the 30 industrial companies comprising the index. A problem with a price-weighted index lies in the distortions that occur when a company in the index chooses to split its stock. On day one the value of a portfolio composed of one share in each of the three stocks is $60. On day two, company a splits its shares three for one, which causes company A’s share price to fall to $10. One share in each of the three companies now costs a total of $40. Someone unaware of company A’s stock split would observe the decline in the index from $60 to $40 and conclude that the market lost a third of its value overnight. This conclusion however would obviously be inaccurate because the decline in value stemmed purely from an accounting change. To deal with this problem, analyses use a divisor to adjust the value of the portfolio before reporting the final value of the index. The divisor ensures the index does not change artificially because of the split. Some interpretation problems arise with a price-weighted index. For one thing, high-value stocks carry more weight than lower-valued issues, which may distort the bigger picture the index purports to provide. Also price weighting carries a bias against a growth stock. As its price raises a growth stock share carries more weigh in the index. After the shares reach too high a price, the company splits the shares thereby knocking the price down and reducing the company’s influence in the index. docsity.com y g ( ) Also the index provides no consideration of any dividends paid by the company. A price- weighted index might begin and end the year at a value of 100.00. It would be incorrect to assume that an investor in the index earned no return; any dividends received are being ignored. The index divisor accounts for artificial price changes due to stock splits. Equal Weighting: An equal weighting index reflects the performance associated with selection of a particular security by chance. For instance, an equal-weighting index of the ten securities would be based on one-tenth of the performance of each of the ten companies. Performance is measured by price change rather than by price alone. Equal weighting of the resulting returns represents the statistical average of random security selection. Equal weighting is theoretically preferable to price weighting. An equal-weighting index can be calculated with or without dividends. Including dividend can only make returns larger, so their omission results in a downward biased measure of market activity. In capitalization weighting, share price is multiplied by the number of outstanding shares. Capitalization Weighting: Capitalization weighting is also called value weighting. This method weights components by the size of the company rather than by the value of a share. Share price is multiplied by the number of shares outstanding. This value is summed for each component of the index, with the total compared to some arbitrary starting value. POPULAR INDEXES: Stock Indexes: Probably no one knows precisely how many different stock indexes exist at any given time even considering just those indexes in the United States. Globally, the chore of maintaining an accurate accounting of each index is probably impossible. Now measures are continually being added and some are deleted as more effective ones come about. The continued success of the options market frequently spawns a new index. A person can trade put and call option on dozens of different U.S stock indexes. These range from the classic Dow Jones Industrial Average to the more contemporary Street.com index. 1. Dow Jones Averages: To the general public, the Dow Jones averages are probably the most familiar stock market indictors. The four primary averages are the industrial average the transportation average, the utilities average, and the Dow Jones composite. Dow Jones & Company introduced the Dow Jones Industrial Average in 1896. Initially the index was based on the value of 12 companies. The first value of the average was 40.94 on May 26, 1896. docsity.com y g ( ) According to a study done by Value Line, in 1991 the S&P500 posted a total return of 36.6%, while the total US. Equity market returned 33.4%. The Russell 3000 index returned 33.7%, much closer to the over all market average than the S&P 500 performance. The Frank Russell Company, from Tacoma, Washington, prepares the Russell 3000. It also provides Russell 2000, which deals only with small cap stocks. In early 1995 the firm established four new indexes based on firm size and investment management style: the Russell Madcap Growth Index, the Russell Midcap Value Index, Russell Top 200 Growth Index, and Russell 200 Value Index. The Russell 3000 index is a mix of both large- and small- capitalization stocks and, to many portfolio managers a better presentation of the broad market. Fixed Income Indexes: More than 400 indexes measure fixed income securities. Despite what the typical investor might think, bonds vary widely in their riskiness and investment characteristics. When comparing performance, investors need to distinguish between corporate bonds, tax-exempt bond, foreign bonds, short and long term bonds, investment grade and junk bonds, and so on. The wide range of available indexes increases the likelihood that investors can identify a benchmark with characteristics they want. The Dow Jones 20 Bond Index is part of the Dow Jones &Company stable of market indexes. Standard &Poor's has more than a dozen indexes of bond, market. Two especially important ones are the S&P Municipal Bond Index and the S&P U.S. government Bond Index. The investment banking firm Salomon Smith Barney prepares about 45 indexes. Most noteworthy is the Salomon Smith Barney Corporate Bond Index. Lehman Brothers and Merrill Lynch compute and maintain another 130 indexes. Moody's Investors Service publishes about 20 of its own. Some indexes are especially specific. J.P. Morgan prepares an emerging markets bond index designed to provide an overview of commercial lending in the developing markets of the world. The company also maintains an index of foreign government bonds. Value Line has an index on 585 convertible bonds. Other indexes deal with mortgaged backed securities. International Indexes: The popularity of international investing has triggered an increasing number of useful global indexes. Some of these owe their creation to the popularity of trading in derivative instruments such as futures and options contracts. 1. European Indexes: In the United Kingdom, the most important index is probably the FT-SE, 100, known as the "Footsie 100". This Financial Times stock exchange is based on the 100 U.K. stocks with the largest capitalization. In Germany, the principal index is the DAX30, specifically introduced for the trading of futures contracts. This total return index includes the reinvestment of dividends on the individual components. In France, the CAC40 and Italy the MIB30 were both created for the trading of equity index futures. 2. Asia and the Pacific Rim: Japan is the principal market in Asia, although Hong Kong and Singapore are rapidly rising in importance. Japan has the Nikkei 225, a price weighted index that has been around since 1949. This is index contains 225 large, activity traded Japanese stocks on the Tokyo Stock docsity.com y g ( ) Exchange. Another Japanese index, TOPIX, includes about 1,200 large companies. A recent addition for futures market purposes is the Nikkei 300, a capitalization weighted index like the S&P500. Australia has the all Ordinaries index, which covers 240 stocks and is capitalization weighted. In Hong Kong, the Hang Seng predominate covering 33 stocks, it is also capitalization weighted. Summary: Indexes are useful in assessing the performances of an investment. It is important, however, to ensure that the chosen index is an accurate proxy for what investors want to measure. A stock index should not be used with a bond portfolio, nor should an index of large- capitalization stocks (like the S & P 500) be used to judge a small-cap stock portfolio. An investor can choose from any of the hundreds of indexes. For equity securities, the Dow Jones Industrial Average and the S & P 500 stock market index are the best known. For the purposes of financial research, the Standard & Poor’s 500 are much more useful than the Dow Jones Industrial Average. A price-weighted index assigns heavy weight to high priced stocks and makes use of a divisor to adjust for stock splits. A capitalization weighted index considers the size of the company and needs no adjustment for stock splits, but must be adjusted for changes in index components, primary stock offerings, and share repurchases. docsity.com