Equity indexes are weighted baskets of individual stocks. The Equity Index is a value that is proportional to the market value of the individual stocks underlying the index. The value of the index changes as the values of the individual stocks change over time. This design allows the index to be used as a measure of the performance of the portfolio of stocks over a specified time period
A particular body specifies the design of the equity index. This may be the stock exchange or a commercial organization. The design is to a degree arbitrary and may be changed from time to time (sometimes in accordance with the specified rules) The principal index design issues include: Weighting schemes – A weighting scheme is required to establish the specific relationship between the constituent stocks and the index.
Equity Index are calculated using the following weighting schemes
Capitalization or value weighting – Under this the weighting of each stock is proportional to its market capitalization (calculated as number of outstanding stocks multiplied by price). The structure dictates that the market capitalization of stocks determines the impact on the index value. A capitalization weighted index will generally not require adjustment unless there are changes in the market value and the number of shares of a constituent stock. The majority of equity index are capitalization weighted
Price weighting – Under this the weighting of each stock is proportional to its price. Under a price-weighted scheme, the same number of each constituent stock is used to construct the index. This structure dictates that high value stocks have a proportionately larger impact on the value of the index. A price-weighted index will generally not require adjustment unless the number of shares outstanding of a constituent stock changes
Equal weighting – Under this all of the constituent stocks have equal weight. This means that given ‘n’ stocks, the weight of each stock is 1/n. An equal weighted index will require adjustment if the price of each constituent stock changes at a different rate to other constituent stocks. Equal weight indexes require frequent rebalancing.
Designing an index
IOSCO’s Technical Committee previously has determined that the following points should be taken into consideration in the design of all indexes, although the application of any particular point may vary depending on whether the index is broad or narrowly based:
· Method of calculation;
· Number of component stocks (degree of correlation or affiliation among component stocks and capitalization of individual component stocks);
· Liquidity of component stocks;
· Dispersion of component stocks within a business sector or across sectors;
· Replacement of component stocks;
· Selection of component stocks; and
· Interaction of clearance and settlement with the cash market.
Share price indices may be classified in various ways. A “world” or “global” share price index (or stock market index) includes (typically large) corporations and corporate groups, regardless of where they are located or traded.
A “national” index indicates the performance of the stock market of a given country—and, by extension, reflects investor sentiment regarding the state of the national economy. The most regularly quoted share price indices are national indices composed of the stocks of large corporations listed on a country’s largest stock exchange. The concept can be extended far beyond an individual exchange by representing the stocks of nearly all publicly traded corporations in an economy. More specialised indices track the performance of specific sectors of the economy, corporations of a certain size or companies with a certain type of management.
Another point to note is the distinction between price return and total return indices (called simply “price” and “return” indices). Some are price indices, while others are return indices, and a third group have both features. Some indices have a number of different versions. These can differ in terms of the manner in which index components are weighted and the way that dividends are accounted for. For example, there are three versions of the S&P index: (i) a price return version, which considers only the price of the components; (ii) a total return version, which accounts for the reinvestment of dividends; and (iii) a net total return version, which accounts for the reinvestment of dividends after the deduction of a withholding tax.