Stock market indices - Investment Fundamentals, Investing in Stock Markets Video Lecture | Investing in Stock Markets - B Com

welcome to the CFA level one
presentation on security market indices
so let's start with the fundamental
question what is a security market index
so essentially a security market index
is a combination or a collection of
securities that effectively represent a
given market or a given segment within a
market some of the most well known
indices in the world are the Dow Jones
Industrial Average the S&P 500 index the
the Nasdaq index so these are some of
the best-known indices in the US in the
rest of the world you have indices such
as the Nikkei that represent the
Japanese stock market the footsie that
represents the British stock market and
so on in Pakistan the most well known
index is the KSC 100 what are the issues
to consider when we construct an index
so essentially how do we choose what
shares to put inside this index the
first thing we need to look at is what
is being measured so let's say that we
want to construct a new index that
measures the performance of banks in
Pakistan now if that's what we want to
measure this is the first thing to
identify when we are constructing our
index so we need to look at what's being
measured and let's say we want to
measure the performance of publicly
traded banks in Pakistan then we have to
decide what based on this objective what
securities should we include clearly we
need to then include securities of banks
and Pakistan so now we might decide for
example to
MCB UBL hbl National Bank etc so so we
have to decide which ones to include we
might decide just to include the biggest
ones or we might decide to include all
the public list treated banks and so on
but clearly some thought process has to
go into which particular banks to
include we then need to decide that
let's say that we make a simplistic
decision that we just want to include
these top four banks then the next
question is what are the waves in the
index so if we create an index with
these four stocks should we have every
stock have equal weight in the index or
should we say that since MCB has the
highest market capitalization this
should have the highest weight so so
clearly there is some thought process
that needs to go into the waves how
often to rebalance means that if we need
to change the weights from time to time
how often should we do that and finally
we should also have rules in place on
when to reconstitute so reconstitute
means changing a security in here so if
at some point we feel that we want to
take out so we might say that every six
months we review and look at which
securities to keep which knot to keep so
if our rule earlier on was the four
largest banks measured by market
capitalization then every six months we
will see whether these four are still
the banks with the largest market cap if
not if say uvl loses some market
capitalization and let's say meson Bank
becomes the fourth biggest bank then we
when we kick out you BL from this index
and stick in
non-bank just as a example another point
related to security market indices is
whether the index is a Christ's return
index or Total Return Index the idea
here being that if we are measuring
let's say very simplistically put that
in a given year say 2010 let's say that
on average all these prices went up by
20% and let's say that the dividend paid
on average was 2% what this means is
that if this is a price return index
then the index will go up by 20% if this
is a Total Return Index then we look at
not just a change in price but also the
dividend so then the total return will
go up by 22%
so now let's talk about the different
ways of weighting and index they are
going to be four methods that we will
talk about and remember this refers to
different ways in which we wait the four
securities in the bond in in our in our
index so let's take a very simple
example let's say we create an index
with three stocks
D and C in a price weighted index the
weight age happens based on the prices
so let's take a situation we have been
in let's say 2009 we stopped the index
so at the start of the year let's say a
has a price of 100 B has a price of 50
and C also has a price of 50 the way we
will create an index errors we say that
the index value at the beginning of 2009
is 200 divided by 3 which is equal to
sixty six point six seven then one year
later let's say that so one year later
let's say that a goes up by 50 percent
and B goes up from 50 to 55 let's say C
stays the same so notice that the stock
with the largest wittich because the
weight is here is based on stock price
so that went up a lot whereas the lower
weight indices did not go up by as much
so what is our new index our new indexes
100 200 255
divided by three which is 85
so our index went up a lot because the
heavyweight stock given that the
weightages based on stock price since
that went up by 50% that had a huge
influence on the fact on on that had a
huge influence on the index so that
highlights a potential issue with doing
price weighted which is that the changes
in index are heavily influenced by
shares that are that are that have a
high price
now this share might have a high price
but it might have a very low
capitalization because the number of
shares outstanding might be low but that
does not show that does not matter over
here
is this a price return versus the total
return the example that I have
illustrated here is actually a price
return because we have only looked at
changes in price we did not even
consider dividends on the other hand if
on average these shares give let's say
the weighted average based on price
these shares gave a dividend of 2% and
we include that 2% dividend in their
index value so if the index value
instead of going up by this percentage
we also factor in the impact of
dividends then this would be called a
Total Return Index there are some nice
examples in the curriculum I am NOT
going
to go over them right now but just the
mean point for you to understand is if
you are simply looking at if the index
price is simply reflecting the stock
prices then this is a price return index
if the index price is also reflecting
the total return then this would be this
would be a total return index and to
give you an example the Dow Jones is one
of the most famous price weighted
indices in the world it is based on 30
of the largest stocks in the u.s. this
is a price weighted index so dividends
are not accounted for how do we deal
with splits so let's say that stock a
does a two-for-one split so what that
implies is that instead of 150 now the
price of a becomes 75 and let's say that
the price of B & C remains the same now
what should the index price be given
that there is no economic change so
somebody who owned this index or owned
the underlying shares even in the same
waited after the split that person still
is no richer or no poorer and since
there is no economic change the the
market index or the security market
index should remain unchanged and how do
we account for that we do so by changing
the denominator notice that now the
value of the index if we just all
the sum of the share prices now is 180
so we need to decide what to divide 180
by in order to get 85 the answer is 2
point 1 2 so essentially what we do is
change the denominator the denominator
pre-split was 3 post-split the
denominator is 2 point 1 2 so key point
is that the index value the index number
is not impacted by splits but the
denominator used in the calculation is i
mentioned that the dow jones is a price
weighted index when the dow jones
started with 30 shares the denominator
was 30 and today many many years later
they have been several several splits so
the denominator now is a very small
number I don't remember what the exact
number is but it's much less than 1 and
that is because every time there is a
split the denominator goes down next
let's talk about equal weighted index so
in a equal weighted index if you have a
b and c then the weighted of all three
stocks is the same so if we go with the
example that we just talked about we had
a situation where stop a was 100 stock b
was 50 and stock c was 50 initially and
if ile increases from 100 250 B goes
from say 50 to 55 and C remains the same
then with an equal weighted index we
assume that a investor has put an equal
amount of money in each so he is not
concerned with
share price what he is concerned about
is the return on each share so notice
that the return here 50% for e4b
the return is 10% for see the return is
0% and for equal weighted index we
basically take the average return so the
average return 50 10 and 0 is 60 over 3
which is equal to 20% compare this with
the return from our previous example
where if we look at the return in the
previous we went from 60 6.67
to 85 so here the return is 27% so here
we only have so big equal weighted we
have 20% in a price weighted the return
was 27% why does the price way to return
so why do we have a higher return if we
are waiting list on price that is
because the the impact of the high price
share is much more when we do a price
weighted index when we do a equal
weighted index then it doesn't matter
what the share prices all that matters
is the return on each each stock in the
index and then we simply take its
average so that's a equal weighted index
now is this a price return or a total
return the answer here again what I have
calculated is a price return because we
are simply looking at the change in
prices if there was an average dividend
of 2% on all these all these talks then
the total return for the index would
have been 20 plus 2 which is equal to 22
percent if if this falls more realistic
then we would actually calculate the
total return using both capital gains
and dividend for each of these shares
and we would then take the average of
those total returns next let's talk
about the market capitalization weighted
index and this is probably one of the
most popular methods for weighting the
different stocks in our index now how
does this work so here we weight based
on market capitalization so if you have
again stocks a B and C and we go with
the same prices we look not just at the
price but we also look at the shares
outstanding so if if a has 1 million
shares outstanding B has 50 B has 50
million shares outstanding and C has 10
million shares outstanding then we look
at the market capitalization to do the
weighted so the market capitalization
for a would be 100 million the market
capitalization for B would be 2 5 0 0
million the market capitalization for C
would be 500 million so the weightages
of the 3 shares would be based on market
cap and the heaviest weight age now
would be 4 stock B and a now we'll have
a relatively low weight age so this is
important to understand and what is the
concept of market float what this is
saying is that sometimes rather than
considering the number of shares
outstanding we actually look at the
number of shares that are available to
the investing public
and an example might be that if with if
with share be let's say 10 million
shares are owned by the founding members
of this company and those shares are not
being traded so rather than use 50
million we will use 40 million so that
would be that would called a market
capitalization weighted index where we
are only using the market float so key
point here is that wittich is based on
market capitalization rather than rather
than the share price or rather than
equal weighted the fourth and final way
of weighting is called fundamental waken
here the weight is based on a
fundamental attributes such as earnings
let's say you have two companies a and B
both have earnings equal to 20 million a
has a market capitalization of 2200
million P has a market cap of 800
million with fundamental weighting both
a and B will have a 50 percent weight in
the index so in what what this is saying
is if a goes up by 10 percent and B goes
up by 20 percent
then our index will go up by 15 percent
on the other hand had this been a market
capitalization based index then a would
have a rated of 20 percent B would have
a weighted of 80 percent and given the
same
the weights based on market
capitalization so how would
so given a going up by 10% and be going
up by 20% how much would the index go up
the index would go up by 0.2 into 10%
plus 0.8 into 20% which is which is 18%
so notice that with a market
capitalization based weighted system we
give a much heavier weight to stock B
which has a higher market capitalization
even though B has the same earnings so
another core point here is that notice
that a is a is a better value stock
while because 420 million of earnings a
has a market capitalization of 200
million so as price earnings ratio is
200 over 20 which is so is PE price
earnings as 10 whereas these PE is 800
over 20 which is 40 so in a
fundamentally weighted system a which
has a much better value in other words a
lower PE gets a relatively high weighted
compared to the 20% weighted in market
capitalization based index and this is
why we say that with fundamental with a
weighting system that is based on
fundamentals such as earnings those
indices will have a value tilt value
tilt means higher weight age for stocks
which have a better value in other words
price is low relative to a certain
fundamental attributes such as earnings
from an exam question perspective in it
the high probability that if there is
something related to fundamental waiting
the key concept is that indices with a
fundamental weighting have a value tilt
rebalancing and the Constitution you
just need to know the meanings of these
terms so rebalancing simply means
adjusting the weights of constituent
securities notice that with price
weighted and with market capitalization
weighted we don't really need to worry
about rebalancing because when price
changes then automatically the weighted
adjusts similarly if the market
capitalization changes automatically the
weighted adjusts so where we really need
to worry about rebalancing is with equal
weighted indices so that's critical so
with equal weighted indices when prices
change then the weights go off so then
you need to make an adjustment and that
adjustment is called rebalancing
reconstitution which I talked about
earlier simply means changing the
Constituent Securities and for any index
there will be a time period such as six
months so every six months we need to go
back and see whether whether we need to
make any changes to the securities that
make up our index so the example I gave
earlier is let's say that in this index
we have one two three four five stocks
and you are picking the five biggest
stocks or the five biggest market cap in
a given sector so if the stock five now
goes down in number to six and another
stock takes its place then you need to
do some reconstitution
users of indices number one they help
you gauge market sentiment so if we take
say the KSC 100 the performance of the
Kaos e100 is a good indicator of the
market sentiment in Pakistan so if the
KSC 100 is going up that means the
sentiment is positive when it goes down
that means the sentiments are negative
indices that proxies for measuring and
modeling returns systemic risk and risk
adjusted performance here if you recall
from our earlier lectures how do we
calculate beta which is the systematic
risk for a security the way we calculate
beta is we look at the returns of a
given stock or portfolio relative to the
return of the market now what is the
market the market typically the the
proxy the best proxy for the market is
index so when we have index as a proxy
for a market it makes it possible for us
to calculate the systematic risk of
stocks and portfolios the the indices
are also proxies for asset classes in
asset allocation models what this means
is so let's say that in Pakistan if we
talk about the the equity asset class
so a given investor wants to put sixty
percent of his money into equities what
does that mean one simple thing to do is
to simply take sixty percent of your
clients money and put it in the stocks
that are in the KSC 100 so the kc 100's
entually provides a proxy for the whole
equity asset class in pakistan
it's also indices are also benchmarks
for actively model portfolios so if a
given investment manager thinks he can
do a good job of picking stocks how do
you figure out whether he is really
doing a good job or not what you can do
is compare his returns with the returns
on the kec100 if he consistently beats
the kc 113 he is doing a good job of
active portfolio management if not then
he isn't doing a good job of active
portfolio management indices also serve
as model portfolios for an index fund
and exchange-traded funds so if you want
to create an index fund or an
exchange-traded fund that reflects the
equities in Pakistan then you simply
follow whatever or buy the shares in the
TSE 100 index
there are indices for equities fixed
income securities as well as alternative
investments so just a few cool points
when we talk about equity indices you
need to understand what we mean by broad
market indices so the KC 100 for example
is a broad market index that that
reflects the entire that sort of as a
reflection of the entire Pakistani stock
market so the way the Keirsey is
constructed it includes representatives
of representative stocks from all the
major sectors in the economy and hence
PSC would be called a broad-based index
if we create another index which is
simply focused on the banking sector so
that is not a broad-based index that
would be called a sector index so sector
indices help determine whether
active managed rather active investment
manager is more successful at stock
selection or sector allocation let me
just explain this phrase because it's
important so let's say that you have a
given investment manager who focuses on
investing in the banking sector so how
do you determine whether that investment
manager is doing a good job of picking
stocks in the banking sector what you
can do is simply look at the return on
the banking index versus the return of
the stock manager who is picking stocks
in the banking sector
if the stock manager does better than
the index that means he is successful at
stock selection if not that means that
he is not so good at stock selection so
if a manager is not good at stock
selection the better thing to do would
be to simply allocate so let's say if we
are allocating 40 percent of investment
portfolio to the banking sector then if
we are not good at stock selection it
just makes sense to allocate to the
sector and when we allocate to the
sector we should just buy the shares in
the relevant banking sector index a
multi market index is one that reflects
multiple markets so you can have a
emerging market index that is
essentially a combination of indices
from various emerging markets such as
India China Pakistan etcetera so so that
would be an example of emerging market
index typically the relative weightages
in the emerging market index of
different country indices would be based
on the GDP of each of
the countries we can also have style
indices so we can have an index that
only reflects different types of market
cap so you can have a large market cap
index which consists of stocks that have
very high market capitalization you can
have small market cap indices such as
the Wilshire 5000 which is an index
consisting of stocks that have small
market capitalization value refers to
value versus growth so value stocks are
generally stocks with relatively low
growth with relatively low p/e ratios so
if a given investment manager only
focuses on value stocks you compare his
performance by looking at an index which
is only made up of value stocks so that
would be called a Value Index a growth
index is one which has talks that have
relatively high growth so if a given
investment manager focuses on growth
oriented stocks then his performance
should be compared to the index of two
essentially a growth index we can also
have mixed indexes so you can have a
large cap value index so this is saying
that this index has talks which are
large gap and which are value stocks so
there is a whole range of combinations
but as long as you understand what I
just said then the basics are covered
fixed income securities this is a
complicated area but you just need to
understand a few points in order to be
to answer questions on the exam the most
important point related to fixed income
indices is that they are challenging or
very difficult to construct why because
there is a very large number and variety
of fixed income securities the
government alone issues a large number
of securities and then every company
might just have one stock but a whole
host of fixed income securities and then
many fixed income securities are not
liquid so in Pakistan for example
corporate bonds are called TF C's and
these bonds exist but they are not very
liquid so if they are not very liquid
pricing information is not easily
available if the pricing information is
not easily available then obviously that
makes it challenging to to trust the
values shown by the corresponding index
so what you need to know is that these
are two major reasons why it is
challenging to construct a fixed income
index next point is that you need to be
aware of the fact that there are some
aggregate fixed income indices which
basically for example you might have a
in the US a fixed income index for the
corporate sector so that would be an
aggregate index but then this can be
divided by market or economic sector to
create more narrowly defined indices so
you could have a corporate bond index
and then within that corporate bond
index you can then define it as various
economic sectors such as Pharma or
technology and so on so the last point
related to fixed income in diseases that
you can also have indices based on the
type of type of fixed income on the so
there are different types of fixed
income indices
would be based on the type of issuer so
you can have an index for government
bonds versus corporate bonds currency
you can have dollar bonds euro bonds yen
bonds you can have indices based on
bonds which have five year maturity ten
year maturity and so on credit quality
you can have bonds for companies that
have double a-plus rating you can have
index for bonds that have triple B
rating and so on so so that's it in
terms of fixed income securities and
finally alternative investments also
have their indices where there is a the
indices for different kinds of
alternative investments we can have
commodity indices but the challenges
with commodity indices are that
commodity indices are generally based on
futures markets and not on the spot
markets hence different in this and
another issue is that different indices
might use the same commodities but
different waves so the performance of an
index can be different from that of
underlying commodities the key reason
for this is actually the first one
because indices are based on futures
markets it is possible that futures
prices are moving somewhat differently
from spot prices and hence price changes
in the spot market might be different
from the price changes in the futures
market and hence the index might not
necessarily move with the spot prices of
the underlying commodities with real
estate indices you need to know that
first of all real estate securities the
big issue is that they are not very
liquid so creating a real estate index
is not easy because the underlying
components of constituents of the index
are not
liquid nevertheless we do have real
estate indices and you simply need to
remember that the major types of real
estate indices are appraisal indices
repeat sale indices and reach and
indices REIT stands for real estate
investment trust and very simplistically
put these are like a mutual fund of real
estate of real estate investments we
will see this in detail later but
briefly the idea being that investors
pool their money and that pool fund goes
to buy a portfolio of real estate
investments and read companies then
issue shares or stocks or units and
those units their pricing is based on
the value of the underlying real estate
investments so these actually of the
various kinds of real estate investments
these are the most liquid and hence we
have a lot of indices based on wheat
prices hedge fund indices since hedge
funds are not regulated every hedge fund
voluntarily contributes its information
to the index provider so what that means
is that there is voluntary reporting of
hedge fund returns as you can imagine
only the best hedge fund performers are
likely to report their performance since
the contribution is voluntary the
constituents which is the hedge funds
rather than the index provider
determined what goes in the index just
to make this distinction clear when we
have say the KS e 100 the the entity
that creates this index decides which
hundred shares go in the KC 100 but
entity that produces index provider is
constrained because it can only include
hedge funds that voluntarily provide
their information the hedge funds that
are providing their information are the
constituents of the index and it is
those constituents that are effectively
deciding what
into the index and for these reasons the
hedge fund returns are going to be
upward biased from an example spective
this is the critical point that
generally hedge fund returns or the
indices the returns of hedge fund
indices are upward biased so that is it
again I just went over the cool points
the it is essential that you go through
the curriculum and practice all the
questions there as well as practice
questions from your study notes and that
is it