Security market indices 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.
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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.
Indices 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 riskadjusted 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 indices representing various asset classes, including equity, fixed-income, commodity, real estate, and hedge fund indices.
Within most asset classes, index providers offer a wide variety of indices, ranging from broad market indices to highly specialized indices based on the issuer’s geographic region, economic development group, or economic sector or other factors.
Proper use of security market indices depends on understanding their construction and management.
PROBLEMS
- A security market index represents the:
- Risk of a security market.
- Security market as a whole.
- Security market, market segment, or asset class.
- Security market indices are:
- Constructed and managed like a portfolio of securities.
- Simple interchangeable tools for measuring the returns of different asset classes.
- Valued on a regular basis using the actual market prices of the constituent securities.
When creating a security market index, an index provider must first determine the:
- Target market.
- Appropriate weighting method.
- Number of constituent securities.
- One month after inception, the price return version and total return version of a single index (consisting of identical securities and weights) will be equal if:
- Market prices have not changed.
- Capital gains are offset by capital losses.
- The securities do not pay dividends or interest.
- The values of a price return index and a total return index consisting of identical equalweighted dividend-paying equities will be equal:
- Only at inception.
- At inception and on rebalancing dates.
- At inception and on reconstitution dates.
- An analyst gathers the following information for an equal-weighted index comprised of assets Able, Baker, and Charlie:
| Security | Beginning of Period Price (h) | End of Period Price (h) | Total Dividends (h) |
| Able | 10.00 | 12.00 | 0.75 |
| Baker | 20.00 | 19.00 | 1.00 |
| Charlie | 30.00 | 30.00 | 2.00 |
The price return of the index is:
A. 1.7 %. B. 5.0 %.
C. 11.4 %.
- An analyst gathers the following information for an equal-weighted index comprised of assets Able, Baker, and Charlie:
| Security | Beginning of Period Price (h) | End of Period Price (h) | Total Dividends (h) |
| Able | 10.00 | 12.00 | 0.75 |
| Baker | 20.00 | 19.00 | 1.00 |
| Charlie | 30.00 | 30.00 | 2.00 |
The total return of the index is:
- 5.0 %. B. 7.9 %.
C. 11.4 %.
An analyst gathers the following information for a price-weighted index comprised of securities ABC, DEF, and GHI:
| Security | Beginning of Period Price (d) | End of Period Price (d) | Total Dividends (d) |
| ABC | 25.00 | 27.00 | 1.00 |
| DEF | 35.00 | 25.00 | 1.50 |
| GHI | 15.00 | 16.00 | 1.00 |
The price return of the index is:
- 24.6 %. B. 29.3 %.
C. 213.9 %.
- An analyst gathers the following information for a market-capitalization-weighted index comprised of securities MNO, QRS, and XYZ:
| Security | Beginning of Period Price (f) | End of Period Price (f) | Dividends per Share (f) | Shares Outstanding |
| MNO | 2,500 | 2,700 | 100 | 5,000 |
| QRS | 3,500 | 2,500 | 150 | 7,500 |
| XYZ | 1,500 | 1,600 | 100 | 10,000 |
The price return of the index is:
- 29.33 %.
- 210.23 %. C. 213.90 %.
- An analyst gathers the following information for a market-capitalization-weighted index comprised of securities MNO, QRS, and XYZ:
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