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Investment Analysis & Portfolio Management (FIN630)

high a price, the company splits the shares thereby knocking the price down and reducing

the company's influence in the index.

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.

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Investment Analysis & Portfolio Management (FIN630)

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.

Since 1928, 30 large blue chip companies have comprised the index. General Electric is the

lone survivor of the original group. The other 29 companies have either merged, changed

names folded, or been replaced with another firm. With 30 stocks in the index, the initial

value of the divisor was 30. Stock splits reduced it to 16.67 later that year.

Changing the index components can result in a substantial change in what the index

measures. Replacing a troubled firm with a strong one clearly makes before and after

components difficult. The capricious nature of this index, along with the other shortcoming

mentioned earlier, are reason why the Dow Jones averages are the seldom used in financial

research or for performance appraisal purposes.

Investors might wonder why the Dow is price-weighted rather than value-weighted.

According to the editors of the Wall Street Journal, the answer lies party in the technology

of Charles Dow's day; he needed something that was easy to figure with paper and pencil:

in fact, he probably never imagined a market-weighted index because there was no ready

means available to make the calculations required. And the Journal's editors today feel

there's no reason to thinker with the formula because, oddly enough, the seemingly simple

method actually works.

Despite its shortcomings, the Dow has always had fierce supporters. An especially vocal

cheerleader was the writer Richard Russell, who helped publicize the Dow Theory technical

analysis system. He recorded these comments in Barron's magazine in 1959;

"The closing prices of the Dow Jones rail and industrial averages give us a complete index

of everything known by anybody that can possibly affect the economy and corporate profits

(excluding acts of God)."

While you won't find many investment advisors willing to go this far out on a limb today,

most still follow the index and take note of it when the news reports it.

The Dow Jones Transportation Average is like the DJIA expect that it includes 20

transportation companies. The Dow Jones Utility Average contains 15 public utility stocks.

The Dow Jones Composite contains all65 stocks in the DJIA, DJTA and DJUA. The

composite index is sometimes referred to as "65 stocks".

In addition to these well-known averages, Dow Jones publishes 105 different industry

groups indexes ion the basic materials, conglomerate, consumer (cyclical), consumer (non-

cyclical), energy, financial, industrial, technology, and utilities areas. To give an idea of the

precision with which some people select their index of choice, one of the Dow Jones

indexes is "computers with IBM", while another is "computers, without IBM" take your

pick. The industry groups are all on a June 30, 1982, value of 100. There are a variety of

other narrowly focused or specialized Dow Jones indexes useful to certain market followers.

2. Standard & Poor's Indexes:

Not surprisingly, the Standard & Poor's Corporation also prepares and publishes a large

number of indexes. The calculation method for all S&P indexes is identical. The S&P 500

Composite is probably the most widely used. This value-weighted index contains 500

NYSE-traded securities. Standard & Poor's describes it as "an index of leading companies

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Investment Analysis & Portfolio Management (FIN630)

in leading industries." It is not, however, the 500 largest U.S stocks, although many people

erroneously believe so.

It is important to recognize that just because there are 500 stocks in the S&P 500 index this

does not mean that the index cannot be swayed by individual stock performance.

Because it is value-weighted, it does not have a problem with the stock splits. Still a divisor

is necessary for three reasons. One reason stems from the impact of the replacement of a

firm in the index.

Second reason is the issuance of additional shares by a firm in the index. A primary offering

essentially brings capital into the index without stock market movement. If no adjustment

were made for the sale of new shares; returns calculated from the index would be biased

upward. A third reason is a corporate decision to purchase the firm's own shares, taking

capital out of the index.

The S&P 500 index is based on an initial value of 10.00 associated with the 1941-1943 time

period. In April 2000, the index stood at about 1,455, meaning that shares values were, on

average, about 146 times what they were during World War II.

In late 1999, the median market value of a stock in the S&P 500 was about $7.3 billion.

Investors in mid-cap or small-cap stock will find a suitable benchmark on the S&P menu.

The S&P Mid Cap 400 as the name suggest, contains 400 mid capitalization. The S&P

Small Cap 600 is 600 small cap stocks.

Other Standard & Poor's indexes include the S&P 100, S&P Financial Stocks, S&P 20

Transportation Stocks, and the S&P $0 Utility Stocks. The S&P 100 ticker symbol OEX, is

especially popular in option users. OEX option provides a convenient way to hedge market

risk or to speculate on market movements. In May 1992 Standard and Poor's, in conjunction

with the well known market research firm BARRA, announced two new indexes designed

to provide a benchmark for the growth and value investment styles. These are the S&P

500/BARRA Growth index and the S&P 500 Value index. These two indexes are

constructed by essentially partitioning the stocks in the S&P 500 by their price to book

ratio. The two groups do not necessarily' contain the same number of securities. On

September 30, 1995, there were 317 stocks in the Value Index and 183 in the Growth Index.

Because there are always 500 stocks in the S&P 500, there will always be a total of 500

stocks in the two indexes.

Others:

The New York Stock Exchange publishes its own indexes based on the industrial firms,

transportation firms, and utilities, among others, traded at the exchange. The most widely

quoted is the NYSE Composite an average of all NYSE listed stocks. The American Stock

Exchange prepares a similar index on its securities as does the NASDAQ market. Value

Line publishes an index based on the securities covered in the Value Line Investment

Survey.

Some portfolio managers find the Russell 3000 index particularly useful. For years S&P

500 index was considered the "best" proxy for the over all stock market, but increasing

evidence indicates this generalization may no longer be true. The S&P500 index is 95

percent comprised of large capitalization stocks, while large caps stocks make up only 73

percent of the market as a whole. Extensive financial report supports the hypothesis that

small capitalization stocks often do better than their larger counterparts. Consequently many

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Investment Analysis & Portfolio Management (FIN630)

portfolio managers consciously include small cap stocks in their funds. The Russell 3000

index is a mixture of both large and small capitalization stocks.

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.

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Investment Analysis & Portfolio Management (FIN630)

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

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.

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