Market Indexes – Equity Chapter

There are two ways to measure index performance: Price Return and Total Return. Total Return includes dividends; Price Return does not.

Weighting Methods

There are five ways to weight assets in an index:

• Price Weighted: Weight based on individual price divided by total prices. Example: $10 and $20 assets on a $30 total = one-third weight for the $10 asset.
• Equal Weighted: All assets have identical weights.
• Market Cap Weighted: Based on the total market capitalization (all shares issued × price).
• Float Adjusted Weighted: Weighted by free float (only tradable shares).
• Fundamental Weighted: Weighted by fundamentals such as dividend yield or P/E ratio.

Calculation Examples

See video.

Index Maintenance

• Rebalancing: Adjust weights of assets; does not change index constituents.
• Reconstitution: Change assets in the index (add/remove constituents).
• Both processes cause index turnover.

Frequency

• Price Weighted: No rebalancing needed (weight follows price).
• Equal Weighted: Most frequent rebalancing (even a small change alters weights).
• Market Cap Weighted: Some automatic adjustment as stocks change price/free float.

Uses of Indexes

• Gauge market sentiment.
• Performance proxy (e.g., S&P 500).
• Asset allocation (asset class proxies).
• Benchmarks for portfolios.
• Basis for investment products (ETFs).

Types of Equity and Fixed Income Indexes

Equity Indexes: Large cap, mid cap, small cap (based on company size); value and growth (style).

Fixed Income Indexes: Challenges: More securities and less liquidity, leading to high replication costs and turnover. Subdivisions include government, agency, collateralized, corporate; style (maturity, credit quality).

Alternative Investment Indexes

Commodity Indexes: Use futures contracts (not spot prices), requiring rollover which affects returns via roll yield and interest rates. Example: expected price for corn next March vs. expected price in two months.

Real Estate Indexes:

• Appraisal indexes (based on asset valuation; lagged updates).
• Repeat sales indexes (based on transaction prices).
• REITs (most liquid for pricing).

Keywords: infrequent transactions, liquid markets.

Hedge Fund Indexes: Issues: voluntary reporting, data overlaps, survivorship bias (indexes only reflect funds that survive, skewing results).

Summary Table: Index Key Points

Type	Definition/Key Method	Notes
Price Weighted	Based on asset price	No rebalancing
Equal Weighted	All assets equal weight	Frequent rebalancing
Market Cap Weighted	Market cap (total shares × price)	Automatic adjustment/Free-float
Float Adjusted	Only free float included	Considers tradable shares only
Fundamental Weighted	Weight on dividends, P/E, etc.	Depends on index’s design goal

Challenges & Concepts

• Fixed Income: Many securities, low liquidity, high turnover, frequent new issues.
• Commodity: Futures-based, continuous rollover needed, roll yield affects returns.
• Real Estate: Appraisal lag, repeat sales and liquidity differences, REITs most liquid.
• Hedge Funds: Voluntary reporting, data overlap, survivorship bias.