Home' Trinidad and Tobago Guardian : May 11th 2014 Contents Thoughtful investors can
gain significant insight on
the market s behaviour by
studying index values and
understanding what the
numerical changes in
indexes might represent.
To help give you the con-
text for judging index performance, it helps to
first know what goes into the numbers reported
by common market indicators.
What is an index, really?
An index is a select group of investments
whose collective performance can be taken to
represent a market as a whole, or at least a
clearly defined subset of that market. While
some indices may be recalculated once a day
or less, indices representing large, liquid and
active markets (such as the US stock market)
are typically recalculated continuously during
trading periods to reflect up-to-the-moment
pricing data and to indicate the direction and
magnitude of the market s price sentiments.
Of course, major US equity indexes are not
simply the sums of the individual prices for the
investments they represent.
Rather, indexes such as the S&P 500 and
Dow Jones Industrial Average are statistical
models of the universes they were created to
mirror. They take the latest prices and adjust
them to better reflect long-term changes in
financial markets, the constituent companies
and the economy.
The numerical values of common indexes
do not directly convey either the actual daily
prices or percentage changes of their con-
stituents, and when viewed as isolated points
of data, major indexes typically provide little or
no actionable significance.
Rather, index values are intended to be viewed
in a series so they can provide time lines that
can chart relative performance from a consistent
An index value today can be compared with
its value days, years or even decades in the past
to give a meaningful estimate of how the market
might have changed over that time.
The components for each index are chosen
according to the stated rules and policies of that
index. Moreover, each index s value is calculated
using its own proprietary formula. As a result,
even though two or more indexes may include
the same company in their statistics, any par-
ticular market price change for that company
is likely to have different effects on each index.
Distinguishing among different
The most commonly cited stock indexes in
the United States---benchmarks such as the
S&P 500, the Dow, the Morgan Stanley Capital
International s EAFE and Russell Investment s
Russell 2000---are actually parts of large index
families. Some indices in those families focus
on specific areas of the market, such as large,
midsized or small companies. Others specialise
in sectors or investing styles such as growth
Each index has its own unique philosophy
and methodology you should consider. Here
are overviews of some of the key factors you
can use to compare them:
• Coverage criteria
Some indices use rigid statistical rules to
select their constituents. For example, Russell
Investment Group ranks substantially all pub-
lically traded stocks by their total market value,
and then assigns each company on that list to
an index based solely on its position on that
list.Others use more fluid processes. For example,
Standard & Poor s analyses and weights the
relative importance of each business sector in
the economy. It then selects cross-sections of
companies from each sector to create stratified
samples that mirror the market.
• Diversified or focused?
Among the most commonly quoted market
benchmarks, the S&P 500 and Russell 1000
can be considered diversified, while the Dow
Jones Industrial Average is not. Rather, it is
composed of 30 of the largest and most venerable
companies in the US economy.
What the Dow might lack in market breadth,
it could make up in depth---it has been calculated
continuously since 1896, allowing direct per-
formance benchmarking that stretches for more
than a century.
• Sector segmentation
Many providers of diversified indices segment
their primary indices into sector subsets.
However, the definitions of sector vary, with
different classification schemes in use. The
Global Industry Classification Standard (GICS)
was developed jointly by Morgan Stanley Capital
International and Standard & Poor s and forms
the basis for each of these firms index sector
distinctions. GICS is composed of 10 sectors,
each of which includes one or more industry
groups drawn from the GICS list of 24 such
The North American Industrial Classification
System (NAICS) and its ancestors such as the
Standard Industrial Classification (SIC) system
are widely used by economists, the Securities
and Exchange Commission and some other
index providers. This system defines more than
400 individual industries in the economy, each
of which can be grouped into one of 24 different
An investor looking to use indices for a sector
rotation strategy should consider the classification
systems used by the indexes.
• Market capitalisation and float:
In the context of indexes, there are no uni-
versally applicable definitions for large-cap,
midcap or small-cap. A company that is listed
as small in one provider s universe may be con-
sidered medium or large in another s. That s
because some index providers view only market
value when making their groupings, while others
may adjust their categorisations to reflect vari-
ances in company age or maturity, business
factors and growth rates.
Float is another factor that leads to variation.
Some index providers consider all shares equally
when assessing the size of a company. Others
consider only the value of shares that can be
publically traded, a statistic known as the free
For example, a company with a large number
of shares held by insiders who are bound by
trading restrictions will have a much smaller
free float than a similar-sized company with
no stock subject to trading restrictions.
Weighting is the practice of adjusting each
constituent s contribution to the index to reflect
its relative size in the index. Weighting is most
typically based on price per share or total com-
In price weighting, a stock whose share price
is $20 will have twice the influence on the index
as a stock whose share price is $10. In capi-
talisation weighting, a constituent whose total
market value is twice as great as another s would
have twice the influence on the index. The DJIA,
for example, uses price-weighting factors in its
calculations, while the S&P 500 uses capital-
• Company domicile
Major stock indices in the United States all
reflect pricing action on US stock exchanges.
But some indexes (such as the S&P 500) include
companies based outside the United States who
list their shares here, while others (such as the
Dow and Russell) limit their constituent universes
to US-domiciled firms.
Index Turnover Some firms follow fixed
schedules for reevaluating their constituent lists
and making changes to those lists. Russell, for
example, undertakes this kind of index revision
once each year, at the end of June. Others
respond more fluidly.
Standard & Poor s analysts continually monitor
their index constituents and make changes to
their indices as conditions warrant, sometimes
as often as daily or weekly.
• Investibility and tracking error:
While it may be impossible to invest directly
in any index, asset managers can create portfolios
that are intended to replicate index performance.
Along the same lines, index architects can design
benchmarks that simplify the process of repli-
cation for portfolio managers. One important
tool for measuring how well a portfolio tracks
an index is tracking error. In its simplest statistical
form, tracking error is the arithmetic difference
between portfolio returns and benchmark
returns; the smaller the difference, the closer
the manager is to the benchmark.
David Fox CFP , senior vice president --
financial advisor, Morgan Stanley Boca West,
Boca Raton, Florida
The author(s) are not employees of Morgan Stanley
Smith Barney LLC ("Morgan Stanley"). The opinions
expressed by the authors are solely their own and do
not necessarily reflect those of Morgan Stanley. The
information and data in the article or publication has been
obtained from sources outside of Morgan Stanley and
Morgan Stanley makes no representations or guarantees
as to the accuracy or completeness of information or
data from sources outside of Morgan Stanley. Neither
the information provided nor any opinion expressed con-
stitutes a solicitation by Morgan Stanley with respect to
the purchase or sale of any security, investment, strategy
or product that may be mentioned.
© 2014 Morgan Stanley Smith Barney LLC. Member
MAY 11 • 2014 www.guardian.co.tt SUNDAY BUSINESS GUARDIAN
ANALYSIS | SBG17
DAVID H FOX
All about indices A brief guide to major
around the world
Standard & Poor's Composite Index of 500
Stocks (S&P 500® Index): The S&P 500 is a
broad-based index of the average performance of
500 widely held US stocks. Many people believe
that the S&P 500 includes the 500 largest stocks
on the New York Stock Exchange. Not true:
Rather, it includes the stocks of companies that
are or have been leaders in their respective indus-
tries and that are listed on the New York Stock
Exchange and the Nasdaq system.
Dow Jones Industrial Average (DJIA): Follow-
ing the returns of 30 well-established, blue-chip
US companies, the DJIA is among the most
renowned of the stock market indexes. However,
the S&P 500 can be considered a more diversi-
fied indicator of the stock market.
Nasdaq Composite: This index was created in
1971 and tracks all domestic and non-US-based
common stocks listed on the National Associa-
tion of Securities Dealers Automatic Quotation
System (Nasdaq) market. The index is composed
of approximately 5,000 stocks that are traded via
this system. Traditionally, the Nasdaq composite
has been considered representative of technol-
ogy stocks; however, today it is composed of an
ever-broadening variety of issues.
MSCI EAFE® Index: Morgan Stanley Capital In-
ternational's Europe, Australasia, Far East
(EAFE) Index is the most prominent of the in-
dexes that track international stock markets. It is
a subset of MSCI's All Country World Index of in-
vestable markets, which reflects the performance
of more than 900 securities across all capitalisa-
tion, sector and style segments in 45 developed
and emerging markets.
Russell 1000® Index: The Russell 1000 Index
measures the performance of the largest publi-
cally traded companies in the US equity market.
It is composed of the 1,000 largest firms as de-
termined by Russell Investment's annual ranking
by market capitalisation.
Russell 2000® Index: The Russell 2000 Index
measures the performance of the small-cap seg-
ment of the US equity market. It includes the
2,000 companies ranked below the Russell 1000
in Russell Investment's annual market-capitalisa-
FTSE 100 Index: This index is part of the FTSE
UK Series and is designed to measure the per-
formance of the 100 largest companies traded on
the London Stock Exchange that pass screening
for size and liquidity.
Nikkei 225 Index: This index is composed of the
225 largest stocks on the Tokyo Stock Exchange.
Barclays Capital US Aggregate Bond Index:
Covering the principal investment-grade sectors
of the US bond market (such as corporate, gov-
ernment and mortgage-backed), this benchmark
is among the most broadly diversified indexes of
bond market total returns.
10-Year US Treasury Bond: The yield on this
long-term US government bond is often looked
to as the foundation bond yield for analysing the
performance potential of other long-term bond
investments. The yield is not an index but a sta-
tistic derived from the reported prices for bond
iMoneyNet Money Fund AveragesTM: These
benchmarks track the averages of taxable and
tax-free money market fund yields on a 7- and
30-day basis. They are not indexes but averages
of reported yields as calculated by the publisher
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