This short write-up goes into detail as to what a Stock Market Index is. This will discuss how one can invest in a Stock Market Index and the Weighting Methods that define the types of indices. The following will be discussed at length:
- Equal Weighting
- Factor Weighting
- Free-Float Adjusted Market Capitalization Weighting
- Fundamental Factor Weighting
- Market-Capitalization Weighting
- Minimum Variance Weighting
- Price Weighting
- Volatility Weighting
Stock Market Index: A Definition
Simply put, a Stock Market Index pertains to a type of Index that measures a Stock Market. It may also measure a subset of it which serves to assist investors in comparing present prices with what had been charted in the past. This is being done so that market performance may be effectively calculated.
The computations are based on the prices of selected stocks. It is usually administered by means of weighted arithmetic mean–we’ll get to that in a bit.
It must be noted that there are two types of indexes:
- The Investable Index
- The Transparent Index
How to Invest in a Stock Market Index
Interested traders would be able to invest in Stock Market Index through the purchase of an index fund. These may be structured as a mutual fund or an exchange-traded fund. Investing in Stock Market Index may also be done through “tracking” an index.
The performance of an index fund and the index itself can be differentiated. Should there be a resulting difference, this is called “tracking error”.
Index Classification Determined Through Weighting Method
Segmentation of Stock Market indices could be done through the index weight methodology which refers to the rules of stock allocation within the index which does not rely on its stock coverage.
There are numerous ways by which Index Weighting can be performed. Some of these bear limitations such as constraints in limits within the set rules. These are methods will be discussed in brief below:
These indices provide constituents stock weights of 1/n. Here, n stands for the total stock number within the index. This technique is able to turn out what are called least-concentrated portfolios. However, many contend that this is a naive strategy as it does not make evident any preference for a single stock. What it does to Small-Cap stocks is overweight it, whilst underweighting Large-Cap stocks. What this ultimately does is render stock indices with higher volatility and lower liquidity compared to Market-Cap weighted index.
These indices are based on risk factors in stocks which are determined through factor models like the Fama–French three-factor model. What these indices take into consideration are factors such as growth, momentum, quality, size, value, volatility, and yield.
Free-Float Adjusted Market Capitalization
These indices are able to adjust the Market-Cap Index weights through the shares of constituents that are outstanding. These are for closely or strategically-held shares that are immediately made public. Governments, institutions, business owners, and employees are the entities who may hold these shares. Should foreign entities be the one to have ownership of these shares, then they are sanctioned by the government in that their usage and ownership is limited.
To note, Free-float adjustments tend to be complicated. In this light, index providers all have their different ways and strategies with regard to free-float adjustments.
Fundamental Factor Weighting
This methodology weights constituent stocks through stock fundamental factors as opposed to stock financial market data. These could include sales, income dividends and other factors that go through the analysis technique of Fundamental Analysis. It is similar to this type of analysis in that it makes assumptions regarding stock markets, that it will apparently merge with an existing price through its fundamental qualities.
This method weighs constituent stocks through its Market Capitalization. Through this process the stock price can also be used for the weighing through its outstanding shares that are to be divided by the entire Market Cap of all the index’s constituents. The Market Cap is determined to be mean-variance efficient. What this means is that the Market Cap produces the highest return for a specified risk level.
Weighted equity index can also make for noteworthy investment portfolios in that they are also mean-variance efficient provided the set of assumptions are correct. The index is also advantageous in light of its high liquidity offering and the impressive capacity of handling investor flows. It is already apparent that these types of portfolios are valued largely in light of its investment performance.
Minimum Variance Weighting
This makes use of a mean-variance optimization procedure. Here, highly volatile stocks are correlated negatively with the rest of the index.
This method is done through the division of the totality of the share prices by the designated price per share within the index. This can be considered as a portfolio by itself that contains only one share of each constituent stock. It can be decreased through a stock split for the constituent stock of the index. This is despite the lack of changes within the basics of the stock. This turns off portfolio managers when they consider these as benchmarks for passive investment techniques. Dow Jones Industrial Average and the Nikkei 225 are just two examples of Price-Weighted indices.
These indices weight stocks through the inverse of the prices that are relative to their volatility within the market. Simply, Price Volatility cannot be defined solely by a certain parameter. To this cause, each provider has his own definition of Price Volatility. While this is the case, there are two (2) common methods with which this can be defined:
- Standard Deviation of 252 days
- Standard Deviation of 156 weeks (this takes into account the price returns)