WHAT IS STOCK INDEX

 

 

A stock market index is a method of measuring a section of the stock market. Many indices are cited by news or financial services firms and are used to benchmark the performance of portfolios such as mutual funds. An index whose value represents the combined values of an assortment of underlying stocks, which may number from a few dozen stocks to thousands of stocks. A well-known stock index is the Dow Jones Industrial Average (DJIA), which comprises the stocks of 30 large and well-established U.S. companies. There are hundreds of stock indices for the United States and foreign markets. Some of the popular foreign stock indices are France's CAC 40, the United Kingdom's FTSE 100 and Japan's Nikkei 225.

 

Stock indices include a specified number of stocks. A base period is selected and the index is given a value for the period, such as 100. Future movements up and down in the prices of the stocks push the index number up or down. Guidelines for establishing the stock index are selected by the exchange.

TYPE OF STOCK INDICES

 

Stock market indices may be classed in many ways. A 'world' or 'global' stock market index includes (typically large) companies without regard for where they are domiciled or traded. Two examples are MSCI World and S&P Global 100.

 

A national index represents the performance of the stock market of a given nation and by proxy, reflects investor sentiment on the state of its economy. The most regularly quoted market indices are national indices composed of the stocks of large companies listed on a nation's largest stock exchanges, such as the American S&P 500, the Japanese Nikkei 225, and the British FTSE 100.

 

The concept may be extended well beyond an exchange. The Dow Jones Total Stock Market Index, as its name implies, represents the stocks of nearly every publicly traded company in the United States, including all U.S. stocks traded on the New York Stock Exchange (but not ADRs) and most traded on the NASDAQ and American Stock Exchange. Russell Investment Group added to the family of indices by launching the Russell Global Index.

 

More specialized 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.

INDEX VERSIONS

 

Some indices, such as the S&P 500, have multiple versions. These versions can differ based on how the index components are weighted and on how dividends are accounted for. For example, there are three versions of the S&P 500 index: price return, which only considers the price of the components, total return, which accounts for dividend reinvestment, and net total return, which accounts for dividend reinvestment after the deduction of a withholding tax. As another example, the Wilshire 4500 and Wilshire 5000 indices have five versions each: full capitalization total return, full capitalization price, float-adjusted total return, float-adjusted price, and equal weight. The difference between the full capitalization, float-adjusted, and equal weight versions is in how index components are weighted.

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, Amex Major Market Index, 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.

 

A modified market cap weighted index is a hybrid between equal weighting and capitalization weighting. It is similar to a general market cap with one main difference: the largest stocks are capped to a percent of the weight of the total stock index and the excess weight will be redistributed equally amongst the stocks under that cap. Moreover, in 2005, Standard & Poor's introduced the S&P Pure Growth Style Index and S&P Pure Value Style Index which was attribute weighted. That is, a stock's weight in the index is decided by the score it gets relative to the value attributes that define the criteria of a specific index, the same measure used to select the stocks in the first place. For these two stocks, a score is calculated for every stock, be it their growth score or the value score (a stock cant be both) and accordingly they are weighted for the index.

CRITICISM OF CAPITALIZATION-WEIGHTING

 

The use of capitalization-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 capitalization-weighted portfolio of all assets. However, 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 capitalization-weighted portfolios is not necessarily the optimal method.

 

As a consequence, capitalization 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 capitalization weighting lead to trend-following strategies that provide an inefficient risk-return trade-off.

 

Also, while capitalization weighting is the standard in equity index construction, different weighting schemes exist. First, while most indices use capitalization 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 capitalization-weighting, equity indices with different weighting schemes have emerged, such as "wealth"-weighted (Morris, 1996), "fundamental"-weighted (Arnott, Hsu and Moore 2005), "diversity"-weighted (Fernholz, Garvy, and Hannon 1998) or equal-weighted indices.

STOCK INDEX FUTURES

 

Agreements to buy or sell a standardized value of a stock index, on a future date at a specified price, such as trading New York Stock Exchange composite index on the New York Futures Exchange (NYFE). As an investment instrument it combines features of securities trading based on stock indices with the features of commodity futures trading. It allows investors to speculate on the entire stock-market's performance, sell an index with a futures contract, or to hedge a long position against a decline in value. Index futures can be used to speculate on the future direction of the stock market (rather than just a few stocks) or to hedge a portfolio of securities against general market movements.

 

A contract for the future delivery of a sum of money based on the value of a stock index (in most cases, 500 times the index). Unlike other futures contracts, in which a given commodity is specified for delivery, stock index futures call for cash settlements, because it is not possible to deliver an actual index.

INDEX FUTURES MARKET

 

The global market for exchange-traded stock market index futures is notionally valued by the Bank for International Settlements at $221,200 million in 2005.

INDEX FUTURES USES

 

Stock index futures are used for hedging, trading, investments.

•	Hedging using stock index futures could involve hedging against a portfolio of shares or equity index options.
•	Trading using stock index futures could involve, for instance, volatility trading (The greater the volatility the greater the likelihood of profit taking - usually taking relatively small but regular profits).
•	Investing via the use of stock index futures could involve exposure to a market or sector without having to actually purchase shares directly.

 

Please note the following cases of equity hedging with index futures:

•	Where your portfolio 'exactly' reflects the index (this is unlikely). Here, your portfolio is perfectly hedged via the index future.
•	Where your portfolio does not entirely reflect the index (this is more likely to be the case). Here, the degree of correlation between the underlying asset and the hedge is not high. So, your portfolio is unlikely to be 'fully hedged'.

BAROMETER OF THE ECONOMY

At the stock exchange, share prices rise and fall depending, largely, on market forces. Share prices tend to rise or remain stable when companies and the economy in general show signs of stability and growth. An economic recession, depression, or financial crisis could eventually lead to a stock market crash. Therefore the movement of share prices and in general of the stock indexes can be an indicator of the general trend in the economy.