Stock market index

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A stock market index is a listing of stocks and a statistic reflecting the composite value of its components. It is used as a tool to represent the characteristics of its component stocks, all of which bear some commonality such as trading on the same stock market exchange, belonging to the same industry, or having similar market capitalizations. Many indices compiled by news or financial services firms are used to benchmark the performance of portfolios such as mutual funds.

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[edit] Types of indices

Stock market indices may be classed in many ways. A broad-base index represents the performance of a whole stock market— and by proxy, reflects investor sentiment on the state of the economy. The most regularly quoted market indices are broad-base indices including the largest listed companies on a nation's largest stock exchange, such as the American Dow Jones Industrial Average and S&P 500 Index, the British FTSE 100, the French CAC 40, the German DAX and the Japanese Nikkei 225.

The concept may be extended well beyond an exchange. The Dow Jones Wilshire 5000 Total Stock Market Index, as its name implies, represents the stocks of nearly every publicly traded company in the United States, including all stocks traded on the New York Stock Exchange and most traded on the NASDAQ and American Stock Exchange. The Europe, Australia, and Far East Index (EAFE), published by Morgan Stanley Capital International, is a listing of large companies in developed economies in the Eastern Hemisphere.

More specialised indices exist tracking the performance of specific sectors of the market. The Morgan Stanley Biotech Index, for example, consists of 36 American firms in the biotechnology industry. Other indices may track companies of a certain size, a certain type of management, or even more specialized criteria— one index published by Linux Weekly News tracks stocks of companies that sell products and services based on the Linux operating environment.

[edit] Weighting

An index may also be classified according to the method used to determine its price. In a Price-weighted index such as the Dow Jones Industrial Average and the NYSE ARCA Tech 100 Index, the price of each component stock is the only consideration when determining the value of the index. Thus, price movement of even a single security will heavily influence the value of the index even though the dollar shift is less significant in a relatively highly valued issue, and moreover ignoring the relative size of the company as a whole. In contrast, a market-value weighted or capitalization-weighted index such as the Hang Seng Index factors in the size of the company. Thus, a relatively small shift in the price of a large company will heavily influence the value of the index. In a market-share weighted index, price is weighted relative to the number of shares, rather than their total value.

Traditionally, capitalization- or share-weighted indices all had a full weighting i.e. all outstanding shares were included. Recently, many of them have changed to a float-adjusted weighting which helps indexing.

[edit] Critique of Capitalisation-Weighting

The use of capitalisation-weighted indices is often justified by the central conclusion of modern portfolio theory that the optimal investment strategy for any investor is to hold the market portfolio, the capitalisation-weighted portfolio of all assets. It should however be noted that empirical tests conclude that market indices are not efficient. This can be explained by the fact that these indices do not include all assets or by the fact that the theory does not hold. The practical conclusion is that using capitalisation-weighted portfolios is not necessarily the optimal method.

As a consequence, capitalisation weighting has been subject to severe criticism (see e.g. Haugen and Baker 1991, Amenc, Goltz, and Le Sourd 2006, or Hsu 2006), pointing out that the mechanics of capitalisation weighting lead to trend-following strategies that provide an inefficient risk-return trade-off.

Also, while capitalisation weighting is the standard in equity index construction, it should be noted that different weighting schemes exist. First, while most indices use capitalisation weighting, additional criteria are often taken into account, such as sales/revenue and net income (see the “Guide to the Dow Jones Global Titan 50 Index”, January 2006). Second, as an answer to the critiques of capitalisation-weighting, equity indices with different weighting schemes have emerged, such as “fundamental”-weighted (Arnott, Hsu and Moore 2005), “diversity”-weighted (Fernholz, Garvy, and Hannon 1998) or equal-weighted indices.

[edit] Indices and passive investment management

There has been an accelerating trend in recent decades to create passively managed mutual funds that are based on market indices, known as index funds. Advocates claim that index funds routinely beat a large majority of actively managed mutual funds; one study claimed that over time, the average actively managed fund has returned 1.8% less than the S&P 500 index. Since index funds attempt to replicate the holdings of an index, they obviate the need for— and thus many costs of— the research entailed in active management, and have a lower "churn" rate (the turnover of securities which lose favor and are sold, with the attendant cost of commissions and capital gains taxes).

Indices are also a common basis for a related type of investment, the exchange-traded fund or ETF. Unlike an index fund, which is priced daily, an ETF is priced continuously, is optionable, and can be sold short.

[edit] Ethical stock market indices

A notable specialised index type is those for ethical investing indices that include only those companies satisfying ecological or social criteria, e.g. those of The Calvert Group, Domini, Dow Jones Sustainability Index and Wilderhill Clean Energy Index.

Another important trend is strict mechanical criteria for inclusion and exclusion to prevent market manipulation, e.g. in Canada when Nortel was permitted to rise to over 50% of the TSE 300 index value. Ethical indices have a particular interest in mechanical criteria, seeking to avoid accusations of ideological bias in selection, and have pioneered techniques for inclusion and exclusion of stocks based on complex criteria. Another means of mechanical selection is mark-to-future methods that exploit scenarios produced by multiple analysts weighted according to probability, to determine which stocks have become too risky to hold in the index of concern.

Critics of such initiatives argue that many firms satisfy mechanical "ethical criteria", e.g. regarding board composition or hiring practices, but fail to perform ethically with respect to shareholders, e.g. Enron. Indeed, the seeming "seal of approval" of an ethical index may put investors more at ease, enabling scams. One response to these criticisms is that trust in the corporate management, index criteria, fund or index manager, and securities regulator, can never be replaced by mechanical means, so "market transparency" and "disclosure" are the only long-term-effective paths to fair markets.

[edit] Environmental stock market indices

An environmental stock market index aims to provide a quantitative measure of the environmental damage caused by the companies in an index. Indices of this nature face much the same criticism as Ethical indices do - that, on some level, the 'score' given is subjective.

However, whereas 'ethical' issues (for example, does a company use a sweatshop) are largely subjective and difficult to score, an environmental impact is often quantifiable through scientific methods. So it is broadly possible to assign a 'score' to (say) the damage caused by a tonne of mercury dumped into a local river. It is harder to develop a scoring method that can compare different types of pollutant - for example does one hundred tonnes or Carbon Dioxide emitted to the air cause more or less damage (via climate change) than one tonne of Mercury dumped in a river (and poisoning all the fish).

Generally, most environmental economists attempting to create an environmental index would attempt to quantify damage in monetary terms. So one tonne of Carbon Dioxide might cause $100 worth of damage, whereas one tonne of Mercury might cause $50,000 (as it is highly toxic). Companies can therefore be given an 'environmental impact' score, based on the cost they impose on the environment. Quantification of damage in this nature is extremely difficult, as pollutants tend to be market externalities and so have no cost by definition.

[edit] Innovations Awards to Stock Indexes

The list of the stock index winners of the William F. Sharpe Indexing Achievement Awards at the annual Super Bowl of Indexing Conference:

[edit] See also

v • d • e
Major United States stock market indexes

Dow Jones Industrial Average (30 large companies; popular indicator) (ETF: NYSE: DJI)
• NYSE Composite Index (ETF: NYSE: NYA)
• NASDAQ Composite (all companies listed on the NASDAQ; with a heavy dose of technology stocks)
• NASDAQ-100 (large NASDAQ-traded non-financial stocks; more volatile) (ETF: NASDAQ: QQQQ)
• S&P 500 (500 large companies; analysis of economic health) (ETF: AMEX: SPY)
• Russell 2000 (small-cap stocks) (ETF: AMEX: IWM)
• Wilshire 5000 (total U.S. market)


[edit] Lists

[edit] References

Amenc, N., F. Goltz, and V. Le Sourd, 2006, “Assessing the Quality of Stock Market Indices”, EDHEC Publication

Arnott, R.D., J. Hsu, and P. Moore, 2005, “Fundamental Indexation”, Financial Analysts Journal 60(2), 83-99.

Fernholz, R., R. Garvy, and J. Hannon, 1998, “Diversity-Weighted Indexing”, Journal of Portfolio Management, 24(2), 74-82

Haugen, R.A., and N.L. Baker, 1991, “The Efficient Market Inefficiency of Capitalization-Weighted Stock Portfolios”, Journal of Portfolio Management

Hsu, Jason, 2006, “Cap-Weighted Portfolios are Sub-optimal Portfolios”, Journal of Investment Management, 4(3), 1-10

[edit] External Links

“EDHEC recommends that institutional investors take greater care in the construction of their benchmarks” http://www.edhec-risk.com/site_edhecrisk/public/features/RISKArticle.2006-10-18.3754

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