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Security Market Indexes

2024 Curriculum CFA Program Level I Equity Investments

Introduction

Investors gather and analyze vast amounts of information about security markets on a continual basis. Because this work can be both time consuming and data intensive, investors often use a single measure that consolidates this information and reflects the performance of an entire security market.

Security market indexes were first introduced as a simple measure to reflect the performance of the US stock market. Since then, security market indexes have evolved into important multi-purpose tools that help investors track the performance of various security markets, estimate risk, and evaluate the performance of investment managers. They also form the basis for new investment products.

 

in·dex, noun (pl. in·dex·es or in·di·ces) Latin indic-, index, from indicare to indicate: an indicator, sign, or measure of something.

Origin of Market Indexes

Investors had access to regularly published data on individual security prices in London as early as 1698, but nearly 200 years passed before they had access to a simple indicator to reflect security market information. To give readers a sense of how the US stock market in general performed on a given day, publishers Charles H. Dow and Edward D. Jones introduced the Dow Jones Average, the world’s first security market index, in 1884. The index, which appeared in The Customers’ Afternoon Letter, consisted of the stocks of nine railroads and two industrial companies. It eventually became the Dow Jones Transportation Average. Convinced that industrial companies, rather than railroads, would be “the great speculative market” of the future, Dow and Jones introduced a second index in May 1896—the Dow Jones Industrial Average (DJIA). It had an initial value of 40.94 and consisted of 12 stocks from major US industries. Today, investors can choose from among thousands of indexes to measure and monitor different security markets and asset classes.

This reading is organized as follows. Section 2 defines a security market index and explains how to calculate the price return and total return of an index for a single period and over multiple periods. Section 3 describes how indexes are constructed and managed. Section 4 discusses the use of market indexes. Sections 5, 6, and 7 discuss various types of indexes, and the final section summarizes the reading. Practice problems follow the conclusions and summary.

Learning Outcomes

The member should be able to:

  1. describe a security market index;

  2. calculate and interpret the value, price return, and total return of an index;

  3. describe the choices and issues in index construction and management;

  4. compare the different weighting methods used in index construction;

  5. calculate and analyze the value and return of an index given its weighting method;

  6. describe rebalancing and reconstitution of an index;

  7. describe uses of security market indexes;

  8. describe types of equity indexes;

  9. describe types of fixed-income indexes;

  10. describe indexes representing alternative investments;

  11. compare types of security market indexes.

Summary

This reading explains and illustrates the construction, management, and uses of security market indexes. It also discusses various types of indexes. Security market indexes are invaluable tools for investors, who can select from among thousands of indexes representing a variety of security markets, market segments, and asset classes. These indexes range from those representing the global market for major asset classes to those representing alternative investments in specific geographic markets. To benefit from the use of security market indexes, investors must understand their construction and determine whether the selected index is appropriate for their purposes. Frequently, an index that is well suited for one purpose may not be well suited for other purposes. Users of indexes must be familiar with how various indexes are constructed in order to select the index or indexes most appropriate for their needs.

Among the key points made in this reading are the following:

  • Security market indexes are intended to measure the values of different target markets (security markets, market segments, or asset classes).

  • The constituent securities selected for inclusion in the security market index are intended to represent the target market.

  • A price return index reflects only the prices of the constituent securities.

  • A total return index reflects not only the prices of the constituent securities but also the reinvestment of all income received since the inception of the index.

  • Methods used to weight the constituents of an index range from the very simple, such as price and equal weightings, to the more complex, such as market-capitalization and fundamental weightings.

  • Choices in index construction—in particular, the choice of weighting method—affect index valuation and returns.

  • Index management includes 1) periodic rebalancing to ensure that the index maintains appropriate weightings and 2) reconstitution to ensure the index represents the desired target market.

  • Rebalancing and reconstitution create turnover in an index. Reconstitution can dramatically affect prices of current and prospective constituents.

  • Indexes serve a variety of purposes. They gauge market sentiment and serve as benchmarks for actively managed portfolios. They act as proxies for measuring systematic risk and risk-adjusted performance. They also serve as proxies for asset classes in asset allocation models and as model portfolios for investment products.

  • Investors can choose from security market indexes representing various asset classes, including equity, fixed-income, commodity, real estate, and hedge fund indexes.

  • Within most asset classes, index providers offer a wide variety of indexes, ranging from broad market indexes to highly specialized indexes based on the issuer’s geographic region, economic development group, or economic sector or other factors.

  • Proper use of security market indexes depends on understanding their construction and management.

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