Stock market index
Market indexes have always been of great importance in the world of security analysis and portfolio management. People from different walk of life use and are affected by market indicators. Investors both individual and institutional use the market index. Index is a benchmark against which they evaluate the performance of their own or institutional portfolio. The technicians or the chartists often base their decisions to buy and sell on the patterns emerging out of the time series data of market indexes. Even the economists and statisticians use stock market indexes to study the trend of growth patterns in the economy, to analyze as well as forecast business cycles and to correlate stock market indexes to economic activities.
II. HISTORY OF STOCK MARKET INDEX
Dow Jones Industrial Average index is the oldest continuously quoted index of stock price performance in USA, which is being computed since 1896. The index consists of a price weighted average of 30 large blue chips stocks. Standard and poor index consisting of 500 stocks another very popular stock index in USA. Both these indexes are based on the market weighted indexes.
Basic idea in an index
Different indexes are computed and compiled for use by the investors. While some indexes employ an equal weighting approach, the others are either price weighted for value weighted. Both these methods are employed in the compilation of stock and consumer price indexes. Stock indexes are directly used in security analysis and portfolio management and consumer price indexes are used in measuring the change of purchasing power but are also useful in security analysis and portfolio management.
Importance
An index has traditionally been used as an information source. By looking at it, one knows how the market is faring. But in recent years, indices find direct applications in finance, in the form of index funds and derivatives. For instance, both the national stock exchanges launched index futures on the standard and poor index. These applications are now a multi trillion dollar industry worldwide. Indices also serve as a benchmark for measuring the performance of fund managers.
III. METHOD OF STOCK INDEX CONSTRUCTION
There are many methods in practice, of construction of stock indices. Each stock exchange has developed its own procedures, weightages, and number of shares to be taken into account for calculation purposes. Some popular methods are explained are:
Price-weighted and quantity-weighted indexes
These two methods are followed in constructing the stock indexes one is price weighted method and the other one is quantity weighted method. In a price weighted index, the basic approach is to sum the prices of the component securities used in the index and divide this sum by the number of components. In other words, a simple arithmetic average is computed. To allow for the impact of stock splits and stock dividends which could destroy the consistency and comparability of price weighted index data over time, an adjustment of either the reported price data or the divisor itself is required. A price weighted index strictly speaking is not an index at all; it is an average.
The concept of indexing involves the comparison of currently computed averages with some base value. For example the current levels of every stock price moves for two possible reasons: news about the company or news about the country. An indexes captures the second part the movements of the stock market as a whole coming from news about the country.
This is done by averaging as each stock contains a mixture of these two elements, stock news and indexes news. When we consider many stocks the individual stock news tends to cancel out. Each stock is given a weight proportional to its market capitalization which is the share price multiplied by the number of shares making up its equity capital.
Being a benchmark comprising several stocks, an index is harder to manipulate than individual than smaller ones. The weak links in an index are the large, illiquid stocks. These allow a manipulator to obtain maximum impact upon the indexes at minimum cost. This is one reason why illiquid stocks should be excluded from a market indexes; indeed the liquidity of a stock in the index should be proportional to its market capitalization.
IV. MORGAN STANLEY CAPITAL INTERNATIONAL (MSCI) METHOD
Morgan Stanley Capital International in short is referred to as MSCI. It provides global indices and benchmark related products and services to investors all over the world. There are at present 51 country indices and several regional indices provided by MSCI. Equity indices constructed by MSCI encompass 23 developed markets and 28 emerging markets. The global investment managers determine investable areas and such regional indices are published by MSCI. Global international portfolio managers use MSCI indices. The MSCI benchmarks are currently used by over 1,200 clients worldwide.
The closing value of the markets is reflected by the MSCI indices, which are calculated once a day. But however the 15 MSCI European developed market country indices and all the major MSCI European regional indices are calculated on a real time basis and are updated intra day every 60 seconds.
Free Float
Total shares outstanding excluding shares held by strategic investors such as governments, corporations, controlling shareholders and management and shares subject to foreign ownership restrictions are referred to as free float by MSCI.
Procedure for construction of indices:
MSCI indices are constructed in the following manner :
Methodology
Full market capitalization of all the index constituents except those, whose free float is less than the minimum required, are included in the MSCI indices. The weighting of constituents with free float less than minimum, are reduced by using a market capitalization factor (MCF). For instance, the MCF of Zee Tele-films which has a law free float is determined as 60 percent of its market capitalization.
The changes to MSCI indices are categorized into structural changes and market driven changes.
A change in industry composition or regulation is referred to as structural change. In any country, industry restructuring generally takes place once in every 18 -24 months. Such changes can occur on the last date of February, May, August and November of any year. Additions and deletions in MSCI index are announced two weeks in advance. Market driven changes on the other hand are influenced by corporate events like new issues, mergers, acquisitions, bankruptcies.
Recent trends
MSCI which is hither to a full market capitalization weighted index, recently turned into a free float weighted index and consequently, all its equity indices are now adjusted for free float. Further, its standard index series presently cover 85 percent of the market instead of 60 percent. The proposed changes would be implemented in two phases, one on November 30, 2001 and second on May 31, 2002 respectively.
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