Nithisha CHALLA

The Russell 2000 index

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The Russell 2000 index

Nithisha CHALLA

In this article, Nithisha CHALLA (ESSEC Business School, Grande Ecole Program – Master in Management, 2021-2023) presents the Russell 2000 index and details its characteristics.

The Russell 2000 index

As we can already notice in the name, Russell 2000 Index is a stock market index that tracks the performance of 2,000 small-cap companies in the United States. It was introduced by the Russell Investment Group in 1984 and is now created, managed, and distributed by FTSE Russell, a subsidiary of the London Stock Exchange Group. The Russell Index family has three indexes in it, Russell 1000, Russell 2000 and the Russell 3000.

The Russell 2000 has historically outperformed the larger-cap S&P 500 Index over the long term. According to data from FTSE Russell, the Russell 2000 has returned an average of 10.7% annually over the past 20 years, compared to an average return of 7.5% for the S&P 500 over the same period.

The Russell 2000 is widely used as a benchmark by active fund managers who specialize in small-cap stocks. As of March 2023, the largest sector in the Russell 2000 was healthcare, followed by technology and financials. The index is market-capitalization weighted, which means that larger companies have a greater impact on the index performance. The index is also used as the basis for exchange-traded funds (ETFs) and other financial products that allow investors to gain exposure to small-cap stocks.

FTSE Russell is known for its commitment to transparency and the accuracy of its index calculations. The company uses a rules-based methodology for selecting and weighting stocks in its indices, and it provides detailed documentation on its methodology and data sources to ensure that investors can make informed decisions about using its indices for benchmarking and investment purposes.

How is the Russell 2000 index represented in trading platforms and financial websites? The ticker symbol used in the financial industry for the Russell 2000 index is “RUT”.

Table 1 below gives the Top 10 stocks in the Russell 2000 index in terms of market capitalization as of January 31, 2023.

Table 1. Top 10 stocks in the Russell 2000 index.
Top 10 stocks in the Russell 2000 index
Source: computation by the author (data: YahooFinance! financial website).

Table 2 gives the sector representation of the Russell 2000 index in terms of number of stocks and market capitalization as of January 31, 2023.

Table 2. Sector representation in the Russell 2000 index.
Sector representation in the Russell 2000 index
Source: computation by the author (data: YahooFinance! financial website).

Calculation of the Russell 2000 index value

The value of the Russell 2000 Index is calculated using a formula that takes into account the market capitalization of the individual stocks that are included in the index. This means the larger companies have a greater impact on the index than the smaller companies.

The Russell 2000 is reconstituted annually, typically in June. During this process, the index is updated to include the most recent data on small-cap stocks, and companies are added or removed from the index based on their market capitalization.

The formula for a market capitalization-weighted index is given by

Market Capitalization Index value

where I is the index value, k a given asset, K the number of assets in the index, Pk the market price of asset k, Nk the number of issued shares for asset k, and t the time of calculation of the index.

In a market capitalization-weighted index, the weight of asset k is given by formula can be rewritten as

Market Capitalization Weighted Index Weight

which clearly shows that the weight of each asset in the index is its market capitalization of the asset divided by the sum of the market capitalizations of all assets.

Note that the divisor, whose calculation is based on the number of shares, is typically adjusted for events such as stock splits and dividends. The divisor is used to ensure that the value of the index remains consistent over time despite changes in the number of outstanding shares.

Use of the Russell 2000 index in asset management

The Russell 2000 index is widely used in asset management as a benchmark for small-cap stocks in the United States. Small-cap stock experts who run active funds frequently use the Russell 2000 as a benchmark for their performance. On the other hand, passive fund managers can create index funds or exchange-traded funds (ETFs) that follow the performance of the Russell 2000 using the Russell 2000 as a base. In addition to serving as a benchmark for active and passive fund managers, the Russell 2000 index is also used by individual investors who are interested in small-cap stocks. Overall, the Russell 2000 index is a valuable tool for asset managers, and it has a significant impact on the investment strategies and decisions made in this market segment.

Benchmark for equity funds

Equity funds are actively managed investment vehicles that pool capital from a number of investors to buy stocks from a variety of industries. The Russell 2000 index serves as a benchmark for fund managers when assessing the performance of their small-cap equity funds. Fund managers might use a variety of investment strategies, such as top-down sector allocation or bottom-up stock selection, to outperform the benchmark.

Investors can get a good idea of how well a small-cap equity fund is doing in relation to the overall market by comparing the fund’s performance to that of the Russell 2000 index. However, it’s crucial to keep in mind that there are additional elements, such as fees, expenses, and the expertise and experience of the fund manager, that can impact the performance of an equity fund.

Financial products around the Russell 2000 index

There are a number of financial products that either provide exposure to the index or use information from the index. Not just the index funds but there are numerous ETFs and other financial products such as mutual funds, futures and options etc.

  • Exchange-Traded Funds, Options Contracts, Futures Contracts, Index funds and Mutual funds.
  • ETFs are the investment funds that are traded like stocks. ETFs based on the Russell 2000 Index include the iShares Russell 2000 ETF and the Vanguard Russell 2000 ETF.
  • Index mutual funds that track the performance of the Russell 2000 Index typically have low expense ratios and are designed to provide returns that closely match the performance of the index.
  • Futures and options contracts based on the Russell 2000 Index are traded on several exchanges, including the Chicago Mercantile Exchange (CME) and the Intercontinental Exchange (ICE).

Historical data for the Russell 2000 index

How to get the data?

The Russell 2000 index is the most common index used in finance, and historical data for the Russell 2000 index can be easily downloaded from the internet.

For example, you can download data for the Russell 2000 index from September 10, 1987 on Yahoo! Finance (the Yahoo! code for Russell 2000 index is ^RUT).

Yahoo! Finance
Source: Yahoo! Finance.

You can also download the same data from a Bloomberg terminal.

R program

The R program below written by Shengyu ZHENG allows you to download the data from Yahoo! Finance website and to compute summary statistics and risk measures about the Russell 2000 index.

Download R file

Data file

The R program that you can download above allows you to download the data for the Russell 2000 index from the Yahoo! Finance website. The database starts on September 10, 1987. It also computes the returns (logarithmic returns) from closing prices.

Table 3 below represents the top of the data file for the Russell 2000 index downloaded from the Yahoo! Finance website with the R program.

Table 3. Top of the data file for the Russell 2000 index.
Top of the file for the Russell 2000 index data
Source: computation by the author (data: Yahoo! Finance website).

Evolution of the Russell 2000 index

Figure 1 below gives the evolution of the Russell 2000 index from September 10, 1987 to December 30, 2022 on a daily basis.

Figure 1. Evolution of the Russell 2000 index.
Evolution of the Russell 2000 index
Source: computation by the author (data: Yahoo! Finance website).

Figure 2 below gives the evolution of the Russell 2000 index returns from September 10, 1987 to December 30, 2022 on a daily basis.

Figure 2. Evolution of the Russell 2000 index returns.
Evolution of the Russell 2000 index return
Source: computation by the author (data: Yahoo! Finance website).

Summary statistics for the Russell 2000 index

The R program that you can download above also allows you to compute summary statistics about the returns of the Russell 2000 index.

Table 4 below presents the following summary statistics estimated for the Russell 2000 index:

  • The mean
  • The standard deviation (the squared root of the variance)
  • The skewness
  • The kurtosis.

The mean, the standard deviation / variance, the skewness, and the kurtosis refer to the first, second, third and fourth moments of statistical distribution of returns respectively.

Table 4. Summary statistics for the Russell 2000 index.
Summary statistics for the Russell 2000 index
Source: computation by the author (data: Yahoo! Finance website).

Statistical distribution of the Russell 2000 index returns

Historical distribution

Figure 3 represents the historical distribution of the Russell 2000 index daily returns for the period from September 10, 1987 to December 30, 2022.

Figure 3. Historical distribution of the Russell 2000 index returns.
Historical distribution of the daily Russell 2000 index returns
Source: computation by the author (data: Yahoo! Finance website).

Gaussian distribution

The Gaussian distribution (also called the normal distribution) is a parametric distribution with two parameters: the mean and the standard deviation of returns. We estimated these two parameters over the period from September 10, 1987 to December 30, 2022. The mean of daily returns is equal to 0.02% and the standard deviation of daily returns is equal to 1.20% (or equivalently 5.88% for the annual mean and 19.38% for the annual standard deviation as shown in Table 3 above).

Figure 4 below represents the Gaussian distribution of the Russell 2000 index daily returns with parameters estimated over the period from September 10, 1987 to December 30, 2022.

Figure 4. Gaussian distribution of the Russell 2000 index returns.
Gaussian distribution of the daily Russell 2000 index returns
Source: computation by the author (data: Yahoo! Finance website).

Risk measures of the Russell 2000 index returns

The R program that you can download above also allows you to compute risk measures about the returns of the Russell 2000 index.

Table 5 below presents the following risk measures estimated for the Russell 2000 index:

  • The long-term volatility (the unconditional standard deviation estimated over the entire period)
  • The short-term volatility (the standard deviation estimated over the last three months)
  • The Value at Risk (VaR) for the left tail (the 5% quantile of the historical distribution)
  • The Value at Risk (VaR) for the right tail (the 95% quantile of the historical distribution)
  • The Expected Shortfall (ES) for the left tail (the average loss over the 5% quantile of the historical distribution)
  • The Expected Shortfall (ES) for the right tail (the average loss over the 95% quantile of the historical distribution)
  • The Stress Value (SV) for the left tail (the 1% quantile of the tail distribution estimated with a Generalized Pareto distribution)
  • The Stress Value (SV) for the right tail (the 99% quantile of the tail distribution estimated with a Generalized Pareto distribution)

Table 5. Risk measures for the Russell 2000 index.
Risk measures for the Russell 2000 index
Source: computation by the author (data: Yahoo! Finance website).

The volatility is a global measure of risk as it considers all the returns. The Value at Risk (VaR), Expected Shortfall (ES) and Stress Value (SV) are local measures of risk as they focus on the tails of the distribution. The study of the left tail is relevant for an investor holding a long position in the Russell 2000index while the study of the right tail is relevant for an investor holding a short position in the Russell 2000 index.

Why should I be interested in this post?

For a number of reasons, management students (as future managers and individual investors) should learn about the Russell 2000 index. The performance of 2000 small-cap American companies is tracked by this stock market index, which is first and foremost well-known and respected. Gaining a deeper understanding of the US small-cap stock market and the businesses that fuel its expansion requires knowledge of the Russell 2000 index. Individual investors can assess the performance of their own investments and those of their organization by comprehending the Russell 2000 index and its components. Last but not least, a lot of businesses base their mutual funds and exchange-traded funds (ETFs) on the Russell 2000 index which can considered as interesting assets to diversify a portfolio.

Related posts on the SimTrade blog

About financial indexes

   ▶ Nithisha CHALLA Financial indexes

   ▶ Nithisha CHALLA Calculation of financial indexes

   ▶ Nithisha CHALLA The business of financial indexes

   ▶ Nithisha CHALLA Float

About other US financial indexes

   ▶ Nithisha CHALLA The DJIA index

   ▶ Nithisha CHALLA The S&P 500 index

   ▶ Nithisha CHALLA The NASDAQ index

   ▶ Nithisha CHALLA The Wilshire 5000 index

About portfolio management

   ▶ Youssef LOURAOUI Portfolio

   ▶ Jayati WALIA Returns

About statistics

   ▶ Shengyu ZHENG Moments de la distribution

   ▶ Shengyu ZHENG Mesures de risques

Useful resources

Wikipedia Russell indexes

Finance Strategists Defining Russell 2000 Index

FTSE Russell The Russell 2000 Index: Small cap index of choice

Motley Fool 10 of the largest Russell 2000 companies

Academic research about risk

Longin F. (2000) From VaR to stress testing: the extreme value approach Journal of Banking and Finance, N°24, pp 1097-1130.

Longin F. (2016) Extreme events in finance: a handbook of extreme value theory and its applications Wiley Editions.

Data

Yahoo! Finance

Yahoo! Finance Data for the Russell 2000 index

About the author

The article was written in April 2023 by Nithisha CHALLA (ESSEC Business School, Grande Ecole Program – Master in Management, 2021-2023).

The NASDAQ index

by

The NASDAQ index

Nithisha CHALLA

In this article, Nithisha CHALLA (ESSEC Business School, Grande Ecole Program – Master in Management, 2021-2023) presents the NASDAQ index and details its characteristics.

The NASDAQ index

NASDAQ was first founded in 1971 and it is an American stock exchange. By market capitalization of shares traded it is the second-largest stock exchange in the world after the New York Stock Exchange (NYSE). As many of the technology and growth companies are listed on the exchange it is a popular benchmark for them. It has around 3000 companies listed on it, including some of the world’s top technology companies like Microsoft, Amazon, Facebook and Google.

The NASDAQ index is a market capitalization-weighted index that tracks the performance of the stocks listed on the NASDAQ exchange. It is widely used by investors and financial analysts to gauge the performance of the technology sector and the broader US economy.

Interestingly, there is a sister index, the Nasdaq Financial 100 that consists only of financial stocks. Both indices debuted together in 1985. The Nasdaq Financial 100 index was given more attention in the early years. However, the Nasdaq-100 has gained popularity over time due to the expansion of tech companies.

How is the NASDAQ index represented in trading platforms and financial websites? The ticker symbol used in the financial industry for the NASDAQ index is “NDAQ”.

Table 1 gives the Top 10 stocks in the NASDAQ index in terms of market capitalization as of August 26, 2022.

Table 1. Top 10 stocks in the NASDAQ index.
Top 10 stocks in the NASDAQ index
Source: computation by the author (data: NASDAQ! financial website).

Table 2 gives the sector representation of the NASDAQ index in terms of number of stocks and market capitalization as of January 31, 2023.

Table 2. Sector representation in the NASDAQ index.
Sector representation in the NASDAQ index
Source: computation by the author (data: ETmoney!).

Calculation of the NASDAQ index value

The NASDAQ index is a value-weighted index (also called a market-capitalization- weighted index). This means the larger companies have a greater impact on the index than the smaller companies.

At the end of each trading day the value of the NASDAQ index is determined in real-time and can be used as a benchmark for the performance of the index’s constituent companies’ current market prices.

The formula for a market-capitalization-weighted index is given by

Market Capitalization Index value

Where I is the index value, k a given asset, K the number of assets in the index, Pk the market price of asset k, Nk the number of issued shares for asset k, and t the time of calculation of the index.

In a market capitalization-weighted index, the weight of asset k is given by formula can be rewritten as

Market Capitalization Weighted Index Weight

which clearly shows that the weight of each asset in the index is its market capitalization of the asset divided by the sum of the market capitalizations of all assets.

Note that the divisor, whose calculation is based on the number of shares, is typically adjusted for events such as stock splits and dividends. The divisor is used to ensure that the value of the index remains consistent over time despite changes in the number of outstanding shares.

Use of the NASDAQ index in asset management

Given that the index is used for performance measuring it is widely used for constructing and analyzing investment portfolios. This index’s primary use is to create investment strategies, mitigate risk, and assess portfolio performance. Investors and asset managers utilize this index as a useful index to measure the overall performance of the market. It is mainly used for benchmarking, passive investing, active management and risk management.

Benchmark for equity funds

There are several indices that are used as a benchmark for equity funds, but the NASDAQ index is notable for its emphasis on businesses that invest in the technology sector, growth stocks, or both. It is primarily used to compare their performance to the overall market or a particular industry. Additionally, it gives investors a way to contrast the performance of various equity funds with various investment strategies or objectives.

While there are many advantages to using indexes as benchmarks, there are also some disadvantages and restrictions. For instance, benchmarks may not always be indicative of the precise investment goals or risk profile of a fund. Furthermore, benchmarks may be distorted by elements like the size or makeup of the companies included in the index.

Financial products around the NASDAQ index

Investors of all levels can invest in the Nasdaq-100 in a variety of ways, including through ETFs, mutual funds, options, futures, and annuities. ETFs that track the Nasdaq-100 are the easiest way to invest in the index. The ETF gives you exposure to all the 100 largest non-financial companies through a single investment. One of the most well-known ETFs that tracks the Nasdaq-100 index is the Invesco QQQ ETF and the First Trust NASDAQ-100 Technology Sector ETF (QTEC). The Nasdaq-100 is regarded as the best way to invest in some of the top non-financial companies listed on the Nasdaq because of its track record of strong index performance.

The Nasdaq-100 includes foreign stocks as well, unlike the S&P 500. Again, unlike the S&P 500, the Nasdaq-100 only permits non-financial companies to list on it. As of April 2023, a few of the international stocks that are a part of the Nasdaq-100 are Baidu from China, Ryanair from Ireland, Garmin from Cayman Island, and Infosys from India.

Index funds that attempt to track the Nasdaq Composite include Fidelity Investments’ FNCMX mutual fund and ONEQ exchange-traded fund. For investors looking for broad exposure to the stock market with relatively low fees, index funds are a popular option.

Historical data for the NASDAQ index

How to get the data?

The NASDAQ index is the most common index used in finance, and historical data for the NASDAQ index can be easily downloaded from the internet.

For example, you can download data for the NASDAQ index from January 5, 1972 on Yahoo! Finance (the Yahoo! code for NASDAQ index is ^IXIC).

Yahoo! Finance
Source: Yahoo! Finance.

You can also download the same data from a Bloomberg terminal.

R program

The R program below written by Shengyu ZHENG allows you to download the data from Yahoo! Finance website and to compute summary statistics and risk measures about the Nasdaq index.

Download R file

Data file

The R program that you can download above allows you to download the data for the Nasdaq index from the Yahoo! Finance website. The database starts on January 2, 1992. It also computes the returns (logarithmic returns) from closing prices.

Table 3 below represents the top of the data file for the Nasdaq index downloaded from the Yahoo! Finance website with the R program.

Table 3. Top of the data file for the Nasdaq index.
Top of the file for the Nasdaq index data
Source: computation by the author (data: Yahoo! Finance website).

Summary statistics for the Nasdaq index

The R program that you can download above also allows you to compute summary statistics about the returns of the Nasdaq index.

Table 4 below presents the following summary statistics estimated for the Nasdaq index:

  • The mean
  • The standard deviation (the squared root of the variance)
  • The skewness
  • The kurtosis.

The mean, the standard deviation / variance, the skewness, and the kurtosis refer to the first, second, third and fourth moments of statistical distribution of returns respectively.

Table 4. Summary statistics for the Nasdaq index.
Summary statistics for the Nasdaq index
Source: computation by the author (data: Yahoo! Finance website).

Evolution of the Nasdaq index

Figure 1 below gives the evolution of the Nasdaq index from January 2, 1992 to December 30, 2022 on a daily basis.

Figure 1. Evolution of the Nasdaq index.
Evolution of the Nasdaq index
Source: computation by the author (data: Yahoo! Finance website).

Figure 2 below gives the evolution of the Nasdaq index returns from January 2, 1992 to December 30, 2022 on a daily basis.

Figure 2. Evolution of the Nasdaq index returns.
Evolution of the Nasdaq index return
Source: computation by the author (data: Yahoo! Finance website).

Statistical distribution of the Nasdaq index returns

Historical distribution

Figure 3 represents the historical distribution of the Nasdaq index daily returns for the period from January 2, 1992 to December 30, 2022.

Figure 3. Historical distribution of the Nasdaq index returns.
Historical distribution of the daily Nasdaq index returns
Source: computation by the author (data: Yahoo! Finance website).

Gaussian distribution

The Gaussian distribution (also called the normal distribution) is a parametric distribution with two parameters: the mean and the standard deviation of returns. We estimated these two parameters over the period from January 2, 1992 to December 30, 2022. The mean of daily returns is equal to 0.02% and the standard deviation of daily returns is equal to 1.20% (or equivalently 5.88% for the annual mean and 19.38% for the annual standard deviation as shown in Table 3 above).

Figure 4 below represents the Gaussian distribution of the Nasdaq index daily returns with parameters estimated over the period from January 2, 1992 to December 30, 2022.

Figure 4. Gaussian distribution of the Nasdaq index returns.
Gaussian distribution of the daily Nasdaq index returns
Source: computation by the author (data: Yahoo! Finance website).

Risk measures of the Nasdaq index returns

The R program that you can download above also allows you to compute risk measures based the returns of the Nasdaq index.

Table 5 below presents the following risk measures estimated for the Nasdaq index:

  • The long-term volatility (the unconditional standard deviation estimated over the entire period)
  • The short-term volatility (the standard deviation estimated over the last three months)
  • The Value at Risk (VaR) for the left tail (the 5% quantile of the historical distribution)
  • The Value at Risk (VaR) for the right tail (the 95% quantile of the historical distribution)
  • The Expected Shortfall (ES) for the left tail (the average loss over the 5% quantile of the historical distribution)
  • The Expected Shortfall (ES) for the right tail (the average loss over the 95% quantile of the historical distribution)
  • The Stress Value (SV) for the left tail (the 1% quantile of the tail distribution estimated with a Generalized Pareto distribution)
  • The Stress Value (SV) for the right tail (the 99% quantile of the tail distribution estimated with a Generalized Pareto distribution)

Table 5. Risk measures for the Nasdaq index.
Risk measures for the Nasdaq index
Source: computation by the author (data: Yahoo! Finance website).

The volatility is a global measure of risk as it considers all the returns. The Value at Risk (VaR), Expected Shortfall (ES) and Stress Value (SV) are local measures of risk as they focus on the tails of the distribution. The study of the left tail is relevant for an investor holding a long position in the Nasdaq index while the study of the right tail is relevant for an investor holding a short position in the Nasdaq index.

Why should I be interested in this post?

For a number of reasons, ESSEC students should learn about the Nasdaq index. The performance of tech-oriented companies is tracked by this stock market index, which is first and foremost well-known and respected. Gaining a deeper understanding of the US stock market and the businesses that fuel its expansion requires knowledge of the Nasdaq index. Management students can assess the performance of their own investments and those of their organization by comprehending the Nasdaq index and its components. Last but not least, a lot of businesses base their mutual funds and exchange-traded funds (ETFs) on the Nasdaq index.

Related posts on the SimTrade blog

About financial indexes

   ▶ Nithisha CHALLA Financial indexes

   ▶ Nithisha CHALLA Calculation of financial indexes

   ▶ Nithisha CHALLA The business of financial indexes

   ▶ Nithisha CHALLA Float

About other US financial indexes

   ▶ Nithisha CHALLA The DJIA index

   ▶ Nithisha CHALLA The S&P 500 index

   ▶ Nithisha CHALLA The Russell 2000 index

   ▶ Nithisha CHALLA The Wilshire 5000 index

About portfolio management

   ▶ Jayati WALIA Returns

   ▶ Youssef LOURAOUI Portfolio

About statistics

   ▶ Shengyu ZHENG Moments de la distribution

   ▶ Shengyu ZHENG Mesures de risques

Useful resources

Academic research about risk

Longin F. (2000) From VaR to stress testing: the extreme value approach Journal of Banking and Finance, N°24, pp 1097-1130.

Longin F. (2016) Extreme events in finance: a handbook of extreme value theory and its applications Wiley Editions.

Data: Yahoo! Finance

Yahoo! Finance

Yahoo! Finance Data for the Nasdaq index

Data: Bloomberg

Bloomberg

Bloomberg Data for the Nasdaq index

About the author

The article was written in April 2023 by Nithisha CHALLA (ESSEC Business School, Grande Ecole Program – Master in Management, 2021-2023).

The DJIA index

by

The DJIA index

Nithisha CHALLA

In this article, Nithisha CHALLA (ESSEC Business School, Grande Ecole Program – Master in Management, 2021-2023) presents the Dow Jones Industrial Average (DJIA) index and details its characteristics.

The DJIA index

The Dow Jones Industrial Average (DJIA) index was created on May 26, 1896, by Charles Dow and Edward Jones, the co-founders of Dow Jones & Company. It is publicly known as the Dow Jones index or the Dow in general. The DJIA is currently owned and managed by The Wall Street Journal.

It is a stock market index in the United States which represents the performance of 30 large-capitalization publicly traded companies. Today, it is no longer limited to just industrial companies like how it was initially and includes stocks from a variety of sectors, such as technology, healthcare, and finance.

Who decides about the selection of stocks in the index? The Wall Street Journal, which owns the index, selects the stocks based on a variety of factors, such as the company’s size and reputation, and the representation of the industries.

The DJIA is a price-weighted index, which means that each stock’s weight in the index is determined by its price per share rather than its market capitalization such as the S&P 500 index (see below for the technical details). The DJIA is published and disseminated in real-time by various financial news outlets and can be accessed by investors and traders around the world.

How is the DJIA index represented in trading platforms and financial websites? The ticker symbol used in the financial industry for the DJIA index is “DJI”.

Table 1 gives the Top 10 stocks in the DJIA index in terms of market capitalization as of January 19, 2023.

Table 1. Top 10 stocks in the DJIA index.
Top 10 stocks in the DJIA index
Source: computation by the author (data: Motley Fool financial website).

Table 2 gives the sector representation of the DJIA index in terms of number of stocks and market capitalization as of January 31, 2023.

Table 2. Sector representation in the DJIA index.
Sector representation in the DJIA index
Source: computation by the author (data: Wikipedia).

Calculation of the DJIA index value

As a price-weighted index, the DJIA has a greater impact on the index value when the stock prices of companies are higher. The DJIA index value is determined solely based on stock prices, disregarding any dividends that the companies that make up the index have paid.

The formula for a price-weighted index is given by

Price Weighted Index value

where I is the index value, k a given asset, K the number of assets in the index, Pk the market price of asset k, and t the time of calculation of the index.

In a price-weighted index, the weight of asset k is given by the following formula

Price Weighted Index Weight

which clearly shows that the weight of each asset in the index is its market price divided by the sum of the market prices of all assets.

Note that the divisor, which is equal to the number of shares, is typically adjusted for events such as stock splits and dividends. The divisor is used to ensure that the value of the index remains consistent over time despite changes in the number of outstanding shares. A more general formula may then be:

Index value

Where D is the divisor which is adjusted over time to account for events such as stock splits and dividends.

Use the DJIA index in asset management

As we all know, investors frequently use the DJIA index as a benchmark. The DJIA index is used by asset managers to compare the returns on their investments to market returns. Given that it is an index that gauges market performance, it supports investors in carrying out key asset management tasks like passive investments, the capacity to assess corporate risk, asset allocation, portfolio management, etc. But we should always be aware that the DJIA does not encompass all markets and industries in the US. As a result, whenever we evaluate the performance of the US market, we should always take other indexes such as the S&P 500 index and the Russell 2000 into account.

Benchmark for equity funds

Now how do we decide if DJIA is a benchmark for equity funds in the US market? Precisely by seeing if the index indicates all the sectors and industries in the market. Since the DJIA is a price-weighted index and only takes the top 30 companies into account, it is not typically used as a benchmark for the entire US market. We should also take into account other diverse indexes, such as the S&P 500 or the Russell 2000, which offer a more complete representation of the market, if we need a benchmark for the entire US market.

Financial products around the DJIA index

There are a number of financial products centered around the DJIA index that can offer investors some insight, as we are aware that it measures the performance of sizable publicly traded companies listed on the New York Stock Exchange (NYSE) and the Nasdaq. I listed the main financial products associated with the DJIA index through which investors can access the index as below:

  • Exchange-Traded Funds, Options Contracts, Futures Contracts, Index funds and Mutual funds.
  • ETFs are the investment funds that are traded like stocks. The SPDR Dow Jones Industrial Average ETF (DIA) and the ProShares Ultra Dow30 ETF are two examples of ETFs that track the DJIA index (DDM)
  • Futures and Options Contracts allow investors to buy or sell the DJIA index at a specific price and date in the future. Primarily to combat market volatility, to generate income through trading strategies, or to make predictions about the index’s future course
  • Mutual funds and index funds tend to focus more on investing in firms that are included in the DJIA index or attempt to replicate the performance of the index by purchasing the same stocks that make up the index

Historical data for the DJIA index

How to get the data?

The DJIA index is the most common index used in finance, and historical data for the DJIA index can be easily downloaded from the internet.

For example, you can download data for the DJIA index from January 2, 1992 on Yahoo! Finance (the Yahoo! code for DJIA index is ^DJI).

Yahoo! Finance
Source: Yahoo! Finance.

You can also download the same data from a Bloomberg terminal.

R program

The R program below written by Shengyu ZHENG allows you to download the data from Yahoo! Finance website and to compute summary statistics and risk measures about the DJIA index.

Download R file

Data file

The R program that you can download above allows you to download the data for the DJIA index from the Yahoo! Finance website. The database starts on January 2, 1992. It also computes the returns (logarithmic returns) from closing prices.

Table 3 below represents the top of the data file for the DJIA index downloaded from the Yahoo! Finance website with the R program.

Table 3. Top of the data file for the DJIA index.
Top of the file for the DJIA index data
Source: computation by the author (data: Yahoo! Finance website).

Summary statistics for the Dow Jones index

The R program that you can download above also allows you to compute summary statistics about the returns of the Dow Jones index.

Table 4 below presents the following summary statistics estimated for the Dow Jones index:

  • The mean
  • The standard deviation (the squared root of the variance)
  • The skewness
  • The kurtosis.

The mean, the standard deviation / variance, the skewness, and the kurtosis refer to the first, second, third and fourth moments of statistical distribution of returns respectively.

Table 4. Summary statistics for the Dow Jones index.
Summary statistics for the Dow Jones index
Source: computation by the author (data: Yahoo! Finance website).

Evolution of the Dow Jones index

Figure 1 below gives the evolution of the Dow Jones index from January 2, 1992 to December 30, 2022 on a daily basis.

Figure 1. Evolution of the Dow Jones index.
Evolution of the Dow Jones index
Source: computation by the author (data: Yahoo! Finance website).

Figure 2 below gives the evolution of the Dow Jones index returns from January 2, 1992 to December 30, 2022 on a daily basis.

Figure 2. Evolution of the Dow Jones index returns.
Evolution of the Dow Jones index return
Source: computation by the author (data: Yahoo! Finance website).

Statistical distribution of the Dow Jones index returns

Historical distribution

Figure 3 represents the historical distribution of the Dow Jones index daily returns for the period from January 2, 1992 to December 30, 2022.

Figure 3. Historical distribution of the Dow Jones index returns.
Historical distribution of the daily Dow Jones index returns
Source: computation by the author (data: Yahoo! Finance website).

Gaussian distribution

The Gaussian distribution (also called the normal distribution) is a parametric distribution with two parameters: the mean and the standard deviation of returns. We estimated these two parameters over the period from January 2, 1992 to December 30, 2022. The mean of daily returns is equal to 0.02% and the standard deviation of daily returns is equal to 1.20% (or equivalently 5.88% for the annual mean and 19.38% for the annual standard deviation as shown in Table 3 above).

Figure 4 below represents the Gaussian distribution of the DJIA index daily returns with parameters estimated over the period from January 2, 1992 to December 30, 2022.

Figure 4. Gaussian distribution of the Dow Jones index returns.
Gaussian distribution of the daily Dow Jones index returns
Source: computation by the author (data: Yahoo! Finance website).

Risk measures of the Dow Jones index returns

The R program that you can download above also allows you to compute risk measures about the returns of the Dow Jones index.

Table 5 below presents the following risk measures estimated for the Dow Jones index:

  • The long-term volatility (the unconditional standard deviation estimated over the entire period)
  • The short-term volatility (the standard deviation estimated over the last three months)
  • The Value at Risk (VaR) for the left tail (the 5% quantile of the historical distribution)
  • The Value at Risk (VaR) for the right tail (the 95% quantile of the historical distribution)
  • The Expected Shortfall (ES) for the left tail (the average loss over the 5% quantile of the historical distribution)
  • The Expected Shortfall (ES) for the right tail (the average loss over the 95% quantile of the historical distribution)
  • The Stress Value (SV) for the left tail (the 1% quantile of the tail distribution estimated with a Generalized Pareto distribution)
  • The Stress Value (SV) for the right tail (the 99% quantile of the tail distribution estimated with a Generalized Pareto distribution)

Table 5. Risk measures for the Dow Jones index.
Risk measures for the Dow Jones index
Source: computation by the author (data: Yahoo! Finance website).

The volatility is a global measure of risk as it considers all the returns. The Value at Risk (VaR), Expected Shortfall (ES) and Stress Value (SV) are local measures of risk as they focus on the tails of the distribution. The study of the left tail is relevant for an investor holding a long position in the S&P 500 index while the study of the right tail is relevant for an investor holding a short position in the S&P 500 index.

Why should I be interested in this post?

For a number of reasons, ESSEC students should learn about the Dow Jones index. The performance of 30 large-cap American companies is tracked by this stock market index, which is first and foremost well-known and respected. Gaining a deeper understanding of the US stock market and the businesses that fuel its expansion requires knowledge of the Dow Jones index. Management students can assess the performance of their own investments and those of their organization by comprehending the Dow Jones index and its components. Last but not least, a lot of businesses base their mutual funds and exchange-traded funds (ETFs) on the Dow Jones index.

Related posts on the SimTrade blog

About financial indexes

   ▶ Nithisha CHALLA Financial indexes

   ▶ Nithisha CHALLA Calculation of financial indexes

   ▶ Nithisha CHALLA The business of financial indexes

   ▶ Nithisha CHALLA Float

About other US financial indexes

   ▶ Nithisha CHALLA The S&P 500 index

   ▶ Nithisha CHALLA The NASDAQ index

   ▶ Nithisha CHALLA The Russell 2000 index

   ▶ Nithisha CHALLA The Wilshire 5000 index

About portfolio management

   ▶ Jayati WALIA Returns

   ▶ Youssef LOURAOUI Portfolio

About statistics

   ▶ Shengyu ZHENG Moments de la distribution

   ▶ Shengyu ZHENG Mesures de risques

Useful resources

Academic research about risk

Longin F. (2000) From VaR to stress testing: the extreme value approach Journal of Banking and Finance, N°24, pp 1097-1130.

Longin F. (2016) Extreme events in finance: a handbook of extreme value theory and its applications Wiley Editions.

Data: Yahoo! Finance

Yahoo! Finance

Yahoo! Finance Data for the DJIA index

Data: Bloomberg

Bloomberg

Bloomberg Data for the DJIA index

About the author

The article was written in April 2023 by Nithisha CHALLA (ESSEC Business School, Grande Ecole Program – Master in Management, 2021-2023).

Float

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Float

Nithisha CHALLA

In this article, Nithisha CHALLA (ESSEC Business School, Grande Ecole Program – Master in Management, 2021-2023) explains float and its use in the construction financial indexes.

What is Float?

The term “float” (sometimes mentioned as “free float”) refers to the quantity of shares that are readily tradable in financial markets. The float is defined as

Float = Total outstanding shares – Closely held shares – Restricted shares

Outstanding shares are the total number of shares issued by the company.

Closely held shares are the shares of a company that are owned by a small number of shareholders and are not traded on a public stock exchange. These shareholders may include company founders, family members, or a small group of private investors.

Restricted shares are the shares that are not transferable until certain conditions are met and are typically held by corporate management, such as executives and directors. Restricted shares are a type of equity compensation that some employees receive.

The float is usually expressed as a percentage of the total number of shares issued by the company.

Float and IPO

When a company conducts an initial public offering (IPO) or a seasoned offering (SEO) to finance its operational activities and investments, it releases a certain number of shares onto the market that are available for purchase by anyone interested in acquiring a piece of the company. The number of shares issued by the company increases the float. Before the IPO, the float is equal to zero. After the IPO, the float increases but may be relatively small as the founder or top managers of the company may want or have to keep some of their shares.

Why is the float important?

The float is crucial for the calculation of market capitalization-weighted stock market indices. The weight of a company’s stock in the index and, consequently, its impact on the performance of the index as a whole, can change depending on whether shares are included in or excluded from the float. Because of this, a lot of indices base their values solely on the shares in the float, known as the float-adjusted market capitalization method.

Stock market liquidity increases as the float increases. As the number of shares that can be purchased and sold increases, it makes it simpler for an investor to enter and exit the market.

High-float stocks and low-float stocks

In the equity market, we often distinguish high-float stocks and low-float stocks according to the percentage of shares that are available for trading in the market. High-float stocks have more supply and more shares available for trading than low-float stocks.

High float stocks have greater liquidity and are less volatile. In a situation where there is extremely heavy demand, supply and demand will become imbalanced, which will lead to extreme price moves.

Example

The percentage of float shares in relation to all outstanding shares is known as the float percentage. Let us consider the case of Amazon. As of September 2021, Amazon had approximately 505 million shares outstanding. Of these shares, approximately 425 million were considered “float shares”. Float shares are the shares available for trading by the public and exclude shares held by insiders, institutional investors, and other long-term investors.

Therefore, Amazon’s float share percentage would be calculated as follows:
(425 million float shares / 505 million outstanding shares) x 100% = 84.16%

This indicates that the public had access to about 84.16% of Amazon’s outstanding shares for trading. Insiders, institutions, and other long-term investors held the remaining 15.84% of the stock.

Indexes using the float

Equity indices that track the performance of a particular group of companies, such as small-cap or mid-cap companies, are frequently created using float-based indexes. The market capitalization of each company, which is determined by multiplying the total number of outstanding shares by the current share market price, is considered in the calculation of these indices.

The Russell 2000 index, which tracks the performance of 2,000 small-cap companies in the US, and the MSCI World Small Cap index, which tracks the performance of small-cap companies in developed markets worldwide, are two of the many examples of indexes that make use of the float.

We present below the formula for a market-capitalization-weighted index and a float-adjusted market-capitalization-weighted index.

Market-capitalization-weighted index

A market capitalization-weighted index is calculated by multiplying the price of each asset in the index by its number of outstanding shares and summing the resulting values. The weighting of each asset in the index is determined by its market capitalization, so that the largest and most influential companies have the greatest impact on the overall performance of the index.

The formula for a market-capitalization-weighted index is given by

Market Capitalization Index value

Where I is the index value, k a given asset, K the number of assets in the index, Pk the market price of asset k, Nk the number of issued shares for asset k, and t the time of calculation of the index.

In a market capitalization-weighted index, the weight of asset k is given by formula can be rewritten as

Market Capitalization Weighted Index Weight

Which clearly shows that the weight of each asset in the index is its market capitalization of the asset divided by the sum of the market capitalizations of all assets.

Note that the divisor, whose calculation is based on the number of shares, is typically adjusted for events such as stock splits and dividends. The divisor is used to ensure that the value of the index remains consistent over time despite changes in the number of outstanding shares.

Float-adjusted market-capitalization-weighted index

In a float-adjusted market-capitalization-weighted index, the market-capitalization weight of each asset is adjusted for its market float. It is also called a free float. Instead of taking into account shares held by insiders, governments, or other entities that might not be available for trading, the weight is adjusted based on the percentage of shares that are actually traded on the open market.

This differs from the market capitalization weighted index as it accounts for the shares outstanding of a company. A float-adjusted market capitalization-weighted index only takes into account shares that are freely available for trading, whereas a market capitalization-weighted index takes into account all outstanding shares, providing a more accurate picture of the performance of the market.

The formula for a float-adjusted market-capitalization-weighted index is given by

Float Adjusted Market Capitalization Index value

Where I is the index value, k a given asset, K the number of assets in the index, Pk the market price of asset k, Nk the number of issued shares for asset k, Fk the float factor of asset k, and t the time of calculation of the index.

In a float-adjusted market-capitalization-weighted index, the weight of asset k is given by formula can be rewritten as

Float Adjusted Market Capitalization Weighted Index Weight

Why should I be interested in this post?

As a key idea in finance and investment, float should be covered by management students. Float has important effects on both managers and investors. Analyzing a company’s financial statements can also benefit from having a solid understanding of floats. When making a choice, a management student who is researching a company’s stock as a potential investment should keep this in mind.

Related posts on the SimTrade blog

   ▶ All posts about Financial techniques

   ▶ Nithisha CHALLA Financial indexes

   ▶ Nithisha CHALLA Calculation of financial indexes

   ▶ Nithisha CHALLA The DJIA index

Useful resources

Bankrate What is a stock float
Business Insider Floating stock: Why it’s important for investors to know a company’s float

CFI What is Floating Stock?

The Economic Times Float and IPO

Russel How are indexes weighted?

About the author

The article was written in April 2023 by Nithisha CHALLA (ESSEC Business School, Grande Ecole Program – Master in Management, 2021-2023).

The investment ecosystem

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The investment ecosystem

Nithisha CHALLA

In this article, Nithisha CHALLA (ESSEC Business School, Grande Ecole Program – Master in Management, 2021-2023) explains the investment ecosystem in financial markets.

Introduction

In the investment ecosystem, there are several blocks to understand: market participants, market products, and market organization.

Market participants

Market participants are individuals, companies, financial institutions, and governments. Some of these participants may issue assets like companies (stocks, commercial paper, and bonds) and governments (bonds). Some of these participants may invest in these assets like individuals or pension funds.

Based on the amount they invest, market participants are segregated as big players and small players. Big players are mostly institutional investors which collect the funds and then invest them. Few examples of institutional investors are mutual funds, pension funds, hedge funds, trusts, charities etc. Big players may also be wealthy individuals (high net worth individuals or HNWI) or family offices. Small players are other individual investors.

Corporates run businesses, including manufacturing, service, and technology firms, and they need capital to expand and maintain their operations. On the other side, we have institutions that consist of fund managers that could be institutional investors but also retail investors as well. These are the people that have capital so the capital flows from the institutions or investment managers who have the money to the corporations that need that money to grow and run their business. The cycle between the two parties is completed when the firms issue back to the investor’s bonds, which are classified as debt, or shares, which are classified as equity.

In the middle of these two groups sit the investment banks they are often referred to as the sell side and they have contacts on both sides of these players. They have corporate clients, and they have institutional investor clients, their job is to match up the institutional investors with the corporates based on risk and return assessments and expectations and investment style to get the deal done. In addition, we have public accounting firms which are the fourth player in the market.

Market Products

Assets

What are assets? In financial language, an asset is that which has some economic value. And assuming that its value increases in the future market participants buy them and that is how it is a part of the investment ecosystem. Few examples for assets are fixed deposit, land, gold, stock, etc.

Asset classes are made up of those investments or securities whose characteristics are the same. Few major asset classes are equity, bonds (fixed income), commodities, and real estate.

Instruments

What are Instruments? Instruments are the ways through which we can invest in different asset classes.

Some of the major instruments we see in markets are direct investing, mutual funds, and exchange-traded funds (ETFs).

  • Direct investing is nothing but investing cash physically in different asset classes or we can digitally buy assets through our accounts
  • Mutual funds are the funds collected by multiple investors and then those are invested in different asset classes. To manage these mutual funds, we have fund managers who will invest on behalf of investors.
  • ETFs are nothing but a basket of securities just like mutual funds, but the only difference is they are traded on stock exchanges.

Market organization

Primary and secondary markets

The primary markets: the initial issuance of assets

The primary market is where new securities, including stocks, bonds, and other financial assets, are first issued by governments or corporations. The primary market is also referred to as the market for new issues.

Companies and governments raise money in the primary market by offering their securities to retail or institutional investors. The securities may be sold through a private placement or an initial public offering (IPO).

There are four main players in the primary market mainly for issuance of securities.
1) Corporates
2) Investors: institutional investors and individual investors
3) Corporate banks
4) Public accounting firms

The secondary markets: the exchange of assets

In the secondary market, fund managers and banks collaborate to trade securities between investors after they have already been issued. On one side, a fund manager may want to purchase securities of a public company, while on the other, a different fund manager may wish to sell those same securities. Investment bankers come between these clients to help facilitate these trades, and this trade is facilitated over the stock exchange. They provide equity research coverage to help fund managers make decisions about buying and selling those securities. And this secondary market trading makes markets liquid. This is what allows you to get in and out of security very easily.

Market infrastructure

Infrastructure providers are the companies which enable the transactions and functioning of different instruments. It means all the digital and physical infrastructure required for the investor is provided by the infrastructure provider. The few common examples of an infrastructure provider are the stock exchange, depositories, and registrar and transfer of agents.

  • Stock exchange: It is the platform where you can sell and buy securities. Here, with the help of a broker and the stock exchange two investors can buy and sell stocks without knowing each other. For example, The TSE is the largest stock exchange in Asia by market capitalization. It is located in Tokyo, Japan and has over 3,500 listed companies.
  • Depositories: These are the companies that store the stocks we buy in electronic form. We can store these stocks through our demat accounts. Depositories help you transfer stock and various other functions like checking the statements, portfolio holdings and transaction information etc. Generally investors directly do not interact with depositories but they approach through a broker who would invest on their behalf. For example: The DTC is one of the largest depositories in the world. It is located in New York City and holds over 3.5 million securities worth trillions of dollars.
  • Registrar and Transfer of Agents (RTA): just like depositories in case of stocks, RTA’s in case of mutual funds. All trades of mutual funds like subscription, redemption, and transfer, are recorded by an RTA. An RTA also helps mutual fund investors in providing their portfolio and statements to them.

Why should I be interested in this post?

As a student and prospective business management graduate, I think it is important to know the investment ecosystem. Firstly, investments play a vital role in the growth and success of companies. Companies need investments to fund their operations, expand their businesses, and create value for their shareholders. Therefore, understanding the investment ecosystem will enable management students to make informed decisions regarding investments that can help drive the growth of the companies they work for or manage in the future.

Related posts on the SimTrade blog

▶ All posts about financial techniques

   ▶ Marie POFF Film analysis: The Wolf of Wall Street

Useful resources

McKinsey (2017) Capital Markets Infrastructure: An Industry Reinventing Itself

Black rock The Investment Stewardship Ecosystem

About the author

The article was written in March 2023 by Nithisha CHALLA (ESSEC Business School, Grande Ecole Program – Master in Management, 2021-2023).

The business of financial indexes

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The business of financial indexes

Nithisha CHALLA

In this article, Nithisha CHALLA (ESSEC Business School, Grande Ecole Program – Master in Management, 2021-2023) explains the business of financial indexes.

Introduction

Indexes are frequently used in the financial sector to measure the evolution of market prices for a set of financial assets over time. These sets of assets can be defined to represent an asset class, country or geographical zone, or sector of the economy, and provide a comprehensive and accurate overview of the market.

Financial indexes serve as a benchmark for assessing the performance of an investor’s asset portfolio and give investors a way to monitor the performance of a given set of assets. By using financial indexes, investors can gain knowledge of market trends and conditions and make informed investment decisions. Index providers are responsible for creating and maintaining financial indexes.

Financial indexes can be developed to track particular geographical areas or market segments and can be created for a variety of asset classes, including equities, bonds, commodities, and currencies. Financial indexes are primarily provided by specialized companies with experience in data compilation and index value calculation, such as S&P Dow Jones Indices, MSCI, and FTSE Russell. Overall, the business of financial indexes is a critical component of the financial industry, providing valuable data and insights to investors.

Key Players

Index providers

An index provider is a specialized business that specializes in developing and computing market indices as well as licensing its intellectual property to be used as the foundation of passive products. The index providers are essential to the investment professionals in charge of looking after these assets because they provide reliable data distribution, sound index construction, and strict index maintenance. The primary activities of an index provider are product development, licensing, distribution, and related service and support.

Index Industry Association (IIA)

The production of indexes has become an industry! And every industry has a professional association. The index industry is no exception. The Index Industry Association (IIA) was founded in 2012. Some of the founding members are MSCI and S&P Dow Jones Indexes.

As stated on the IIA website, the association mandate is “to educate investors on the attributes and role of indexes within the investment process, to advocate for the interests of index users and providers worldwide, and to push for industry standards of best practice, independence and transparency”.

Business models

Index providers typically employ one of the following business models to make money from their indexes: licensing, creating index-linked products, getting charged for index inclusion, and selling data for index-related research and analysis.

Licensing

Index providers make money by licensing financial institutions like asset managers, banks, and insurance companies to use their indexes. These financial institutions pay a fee to the index provider for the right to use the indexes as a benchmark for their investment products, such as exchange-traded funds (ETFs) and index funds.

Creation of index-linked products

Index providers make money by developing their own index-linked products, such as index funds and ETFs. The investors that are invested in the product pay a management fee to the index provider.

Selling data

By selling the data that has been produced from the history, research, and analysis, the index providers make money.

Regulation of indexes

Index providers build and maintain indexes. In order to ensure that the index accurately reflects the performance of the market or sector it is meant to represent, they are in charge of defining the methodology used to construct the index, choosing the stocks or bonds included in the index, and performing routine index rebalancing.

Beyond the activity of index providers, financial authorities play a role to authorize indexes. The main objective of authorization is to safeguard investors who use the index as a benchmark for their investment decisions and to make sure that the index accurately reflects the performance of the market or sector it is meant to represent. In the United States, the US Securities and Exchange Commission (SEC) has the power to approve specific indexes that serve as the foundation for exchange-traded funds (ETFs) and other investment products. This is done to make sure that these products operate in the best interests of investors and are compliant with SEC regulations.

Why should I be interested in this post?

A wide range of professionals, including portfolio managers, investment advisors, and financial analysts, use financial indexes, which are a crucial part of the financial sector. Financial indexes change over time to take into account adjustments to the economy and market conditions.

You can stay on top of the curve and adjust to changes in the industry by staying informed of the most recent financial index developments. So, in my opinion, studying the business of financial indexes can give business students useful skills and knowledge that they can use in a variety of fields and jobs.

Related posts on the SimTrade blog

About financial indexes

   ▶ Nithisha CHALLA Financial indexes

   ▶ Nithisha CHALLA Calculation of financial indexes

Examples of financial indexes

   ▶ Nithisha CHALLA The S&P 500 index

   ▶ Nithisha CHALLA The Euro Stoxx 50 index

   ▶ Nithisha CHALLA The FTSE 100 index

   ▶ Nithisha CHALLA The CSI 300 index

   ▶ Nithisha CHALLA The Nikkei 225 index

Useful resources

Index Industry Association (IIA)

S&P Global Who’s Behind the Index?

Committee for Economic Development of The Conference Board (CED) The Financial Index Industry

K&L Gates SEC solicits comments on whether index providers, model portfolio providers, and pricing services are investment advisers: seeking a problem for a “solution”

About the author

The article was written in March 2023 by Nithisha CHALLA (ESSEC Business School, Grande Ecole Program – Master in Management, 2021-2023).

The S&P 500 index

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The S&P 500 index

Nithisha CHALLA

In this article, Nithisha CHALLA (ESSEC Business School, Grande Ecole Program – Master in Management, 2021-2023) presents the S&P 500 index and details its characteristics.

The S&P 500 index

The performance of 500 major capital companies listed on the US stock exchange is summarized by a financial index called the S&P 500 index. The stocks of the S&P 500 index are traded on the New York Stock Exchange and NASDAQ, which are the two major stock exchanges in the United States of America. This index serves as a benchmark for the American stock market and investors use it to monitor the performance of the market. The selection of 500 stocks only is deemed enough to represent the stock market (in terms of market capitalization).

The S&P 500 index was first established by Standard & Poor’s, a provider of financial services, on March 4, 1957. In order to provide a comprehensive assessment of the U.S. stock market, the index consists of a range of large-capital businesses from various industries and sectors. The S&P 500 index is currently managed by the index provider S&P Dow Jones Indices (a division of S&P Global).

Who makes the shortlist of the index and how the field is narrowed down? The S&P Dow Jones Indices oversees the selection procedure for index inclusion. The public float, financial viability, market capitalization, and a diverse representation of the US stock market—including technology, healthcare, financials, consumer goods, etc.—are some of the key criteria used to define the composition of the index.

How is the S&P 500 index represented in trading platforms and financial websites? The ticker symbol used in the financial industry for the S&P 500 index is “SPX”.

Table 1 gives the Top 10 stocks in the S&P 500 index in terms of market capitalization as of January 31, 2023.

Table 1. Top 10 stocks in the S&P 500 index.
Top 10 stocks in the S&P 500 index
Source: computation by the author (data: YahooFinance! financial website).

Table 2 gives the sector representation of the S&P 500 index in terms of number of stocks and market capitalization as of January 31, 2023.

Table 2. Sector representation in the S&P 500 index.
Sector representation in the S&P 500 index
Source: computation by the author (data: YahooFinance! financial website).

Calculation of the S&P 500 index value

The S&P 500 index is a value-weighted index (also called a market-capitalization- weighted index). This means the larger companies have a greater impact on the index than the smaller companies.

At the end of each trading day the value of the S&P 500 index is determined in real-time and can be used as a benchmark for the performance of the index’s constituent companies’ current market prices.

The formula to compute the S&P 500 index is given by

SP500 Index value

where I is the index value, k a given asset, K the number of assets in the index, Pk the market price of asset k, Nk the number of issued shares for asset k, and t the time of calculation of the index.

In a S&P 500 index, the weight of asset k is given by formula can be rewritten as

SP500 Index Weight

which clearly shows that the weight of each asset in the index is its market capitalization of the asset divided by the sum of the market capitalizations of all assets.

The divisor, whose calculation is based on the number of shares, is typically adjusted for events such as stock splits and dividends. The divisor is used to ensure that the value of the index remains consistent over time despite changes in the number of outstanding shares.

Note that there are two versions of the S&P 500 index: one which includes the performance of the company as well as the dividends the companies pay (so it is a dividend included index), and another one which only considers the performance of the company but does not consider the dividends.

Use of the S&P 500 index in asset management

Given that the index is used for performance measuring it is widely used for constructing and analyzing investment portfolios. This index’s primary use is to create investment strategies, mitigate risk, and assess portfolio performance. Investors and asset managers utilize this index as an useful index to measure the overall performance of the market.

Benchmark for equity funds

There are a number of indices used as a benchmark for equity funds but the S&P 500 index particularly focuses on the large capped companies in the US market. It is mainly differentiated by the asset class the index is focusing on and the investment strategies followed by the companies. For Example: DJIA uses price weighted stock strategy for the top 30 blue chip companies, whereas the NASDAQ Composite Index uses market capitalization-weighted index of more than 3,000 stocks in the NASDAQ Composite.

Financial products around the S&P 500 index

There are a number of financial products that either provide exposure to the index or use information from the index. Not just the index funds but there are numerous ETFs and specific sector related indices which provide exposure to the S&P 500 index. Other financial products would be mutual funds, futures and options etc.

Historical data for the S&P 500 index

How to get the data?

The S&P 500 index is the most common index used in finance, and historical data for the S&P 500 index can be easily downloaded from the internet.

For example, you can download historical data for the S&P 500 index from December 30, 1927 on Yahoo! Finance (the Yahoo! code for S&P 500 index is ^GSPC).

Yahoo! Finance
Source: Yahoo! Finance.

You can also download the same data from a Bloomberg terminal.

R program

The R program below written by Shengyu ZHENG allows you to download the data from Yahoo! Finance website and to compute summary statistics and risk measures about the S&P 500 index.

Download R file

Data file

The R program that you can download above allows you to download the data for the S&P 500 index from the Yahoo! Finance website. The database starts on December 30, 1927. It also computes the returns (logarithmic returns) from closing prices.

Table 3 below represents the top of the data file for the S&P 500 index downloaded from the Yahoo! Finance website with the R program.

Table 3. Top of the data file for the S&P 500 index.
Top of the file for the S&P 500 index data
Source: computation by the author (data: Yahoo! Finance website).

Summary statistics for the S&P 500 index

The R program that you can download above also allows you to compute summary statistics about the returns of the S&P 500 index.

Table 4 below presents the following summary statistics estimated for the S&P 500 index:

  • The mean
  • The standard deviation (the squared root of the variance)
  • The skewness
  • The kurtosis.

The mean, the standard deviation / variance, the skewness, and the kurtosis refer to the first, second, third and fourth moments of statistical distribution of returns respectively.

Table 4. Summary statistics for the S&P 500 index.
Summary statistics for the S&P 500 index
Source: computation by the author (data: Yahoo! Finance website).

Evolution of the S&P 500 index

Figure 1 below gives the evolution of the S&P 500 index from December 30, 1927 to December 30, 2022 on a daily basis.

Figure 1. Evolution of the S&P 500 index.
Evolution of the S&P 500 index
Source: computation by the author (data: Yahoo! Finance website).

Figure 2 below gives the evolution of the S&P 500 index returns from December 30, 1927 to December 30, 2022 on a daily basis.

Figure 2. Evolution of the S&P 500 index returns.
Evolution of the S&P 500 index return
Source: computation by the author (data: Yahoo! Finance website).

Statistical distribution of the S&P 500 index returns

Historical distribution

Figure 3 represents the historical distribution of the S&P 500 index daily returns for the period from December 30, 1927 to December 30, 2022.

Figure 3. Historical distribution of the S&P 500 index returns.
Historical distribution of the daily S&P 500 index returns
Source: computation by the author (data: Yahoo! Finance website).

Gaussian distribution

The Gaussian distribution (also called the normal distribution) is a parametric distribution with two parameters: the mean and the standard deviation of returns. We estimated these two parameters over the period from December 30, 1927 to December 30, 2022. The mean of daily returns is equal to 0.02% and the standard deviation of daily returns is equal to 1.20% (or equivalently 5.88% for the annual mean and 19.38% for the annual standard deviation as shown in Table 3 above).

Figure 4 below represents the Gaussian distribution of the S&P 500 index daily returns with parameters estimated over the period from December 30, 1927 to December 30, 2022.

Figure 4. Gaussian distribution of the S&P 500 index returns.
Gaussian distribution of the daily S&P 500 index returns
Source: computation by the author (data: Yahoo! Finance website).

Risk measures of the S&P 500 index returns

The R program that you can download above also allows you to compute risk measures about the returns of the S&P 500 index.

Table 5 below presents the following risk measures estimated for the S&P 500 index:

  • The long-term volatility (the unconditional standard deviation estimated over the entire period)
  • The short-term volatility (the standard deviation estimated over the last three months)
  • The Value at Risk (VaR) for the left tail (the 5% quantile of the historical distribution)
  • The Value at Risk (VaR) for the right tail (the 95% quantile of the historical distribution)
  • The Expected Shortfall (ES) for the left tail (the average loss over the 5% quantile of the historical distribution)
  • The Expected Shortfall (ES) for the right tail (the average loss over the 95% quantile of the historical distribution)
  • The Stress Value (SV) for the left tail (the 1% quantile of the tail distribution estimated with a Generalized Pareto distribution)
  • The Stress Value (SV) for the right tail (the 99% quantile of the tail distribution estimated with a Generalized Pareto distribution)

Table 5. Risk measures for the S&P 500 index.
Risk measures for the S&P 500 index
Source: computation by the author (data: Yahoo! Finance website).

The volatility is a global measure of risk as it considers all the returns. The Value at Risk (VaR), Expected Shortfall (ES) and Stress Value (SV) are local measures of risk as they focus on the tails of the distribution. The study of the left tail is relevant for an investor holding a long position in the S&P 500 index while the study of the right tail is relevant for an investor holding a short position in the S&P 500 index.

Why should I be interested in this post?

For a number of reasons, ESSEC students should learn about the S&P 500 index. The performance of 500 large-cap American companies is tracked by this stock market index, which is first and foremost well-known and respected. Gaining a deeper understanding of the US stock market and the businesses that fuel its expansion requires knowledge of the S&P 500 index. Management students can assess the performance of their own investments and those of their organization by comprehending the S&P 500 index and its components. Last but not least, a lot of businesses base their mutual funds and exchange-traded funds (ETFs) on the S&P 500 index.

Related posts on the SimTrade blog

About financial indexes

   ▶ Nithisha CHALLA Financial indexes

   ▶ Nithisha CHALLA Calculation of financial indexes

   ▶ Nithisha CHALLA The business of financial indexes

   ▶ Nithisha CHALLA Float

About other US financial indexes

   ▶ Nithisha CHALLA The DJIA index

   ▶ Nithisha CHALLA The NASDAQ index

   ▶ Nithisha CHALLA The Russell 2000 index

   ▶ Nithisha CHALLA The Wilshire 5000 index

About portfolio management

   ▶ Jayati WALIA Returns

   ▶ Youssef LOURAOUI Portfolio

About statistics

   ▶ Shengyu ZHENG Moments de la distribution

   ▶ Shengyu ZHENG Mesures de risques

Useful resources

Academic research about risk

Longin F. (2000) From VaR to stress testing: the extreme value approach Journal of Banking and Finance, N°24, pp 1097-1130.

Longin F. (2016) Extreme events in finance: a handbook of extreme value theory and its applications Wiley Editions.

Data: Yahoo! Finance

Yahoo! Finance

Yahoo! Finance Historical data for the S&P 500 index

Data: Bloomberg

Bloomberg

Bloomberg Data for the S&P 500 index

About the author

The article was written in March 2023 by Nithisha CHALLA (ESSEC Business School, Grande Ecole Program – Master in Management, 2021-2023).

Calculation of financial indexes

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Calculation of financial indexes

Nithisha CHALLA

In this article, Nithisha CHALLA (ESSEC Business School, Grande Ecole Program – Master in Management, 2021-2023) explains the calculation of financial indexes.

Introduction

A stock market index keeps tabs on the gains and losses made by a specific selection of stocks or other assets. In other words, the index determines how share prices for various companies have changed. The performance of a market index can be quickly evaluated to ascertain the state of the stock market. It also serves as a template for financial institutions to use when creating index funds and exchange-traded funds (ETFs).

Definition

What is an index? In financial markets, there are many sectors, segments and business lines, and if you have to statistically measure the performance of these sectors we need a reference which is called an index. Simply, it is a group of securities or financial instruments which represents the performance of a specific segment of the market.

Calculation

Then the index value has to be calculated with a specific formula. There are different calculation methods for financial indexes: price-weighted index, market-capitalization-weighted index, equal-weighted index and fundamentals-weighted index.

The general formula for a financial index is given by

Index value

where I is the index value, P the asset market price, k a given asset, K the number of assets in the index, wk the weight of asset k in the index, and t is the time of calculation of the index.

Note: the index It at time t is divided by the value of the index at the beginning I0 and multiplied by 100.

Price-Weighted Index

A price-weighted index is calculated by summing the prices of all the assets in the index and dividing by a divisor equal to the number of assets.

The formula for a price-weighted index is given by

Price Weighted Index value

where I is the index value, k a given asset, K the number of assets in the index, Pk the market price of asset k, and t the time of calculation of the index.

In a price-weighted index, the weight of asset k is given by formula can be rewritten as

Price Weighted Index Weight

which clearly shows that the weight of each asset in the index is its market price divided by the sum of the market prices of all assets.

Note that the divisor, which is equal to the number of shares, is typically adjusted for events such as stock splits and dividends. The divisor is used to ensure that the value of the index remains consistent over time despite changes in the number of outstanding shares. A more general formula may then be:

Index value

where D is the divisor which is adjusted over time to account for events such as stock splits and dividends.

In a price-weighted index, the higher-priced stocks move the index more than the lower-priced stocks.

The most popular price-weighted index in the world is likely the Dow Jones Industrial Average (DJIA). It consists of 30 different stocks in the US market.

Market-Capitalization-Weighted Index

A market capitalization-weighted index is calculated by multiplying the price of each asset in the index by its number of outstanding shares and summing the resulting values. The weighting of each asset in the index is determined by its market capitalization, so that the largest and most influential companies have the greatest impact on the overall performance of the index.

The formula for a market-capitalization-weighted index is given by

Market Capitalization Index value

where I is the index value, k a given asset, K the number of assets in the index, Pk the market price of asset k, Nk the number of issued shares for asset k, and t the time of calculation of the index.

In a market capitalization-weighted index, the weight of asset k is given by formula can be rewritten as

Market Capitalization Weighted Index Weight

which clearly shows that the weight of each asset in the index is its market capitalization of the asset divided by the sum of the market capitalizations of all assets.

Note that the divisor, whose calculation is based on the number of shares, is typically adjusted for events such as stock splits and dividends. The divisor is used to ensure that the value of the index remains consistent over time despite changes in the number of outstanding shares.

Float-adjusted market-capitalization-weighted index

In a float-adjusted market-capitalization-weighted index, the market-capitalization weight of each asset is adjusted for its market float. It is also called a free float. Instead of taking into account shares held by insiders, governments, or other entities that might not be available for trading, the weight is adjusted based on the percentage of shares that are actually traded on the open market.

This differs from the market capitalization weighted index as it accounts for the shares outstanding of a company. A float-adjusted market capitalization-weighted index only takes into account shares that are freely available for trading, whereas a market capitalization-weighted index takes into account all outstanding shares, providing a more accurate picture of the performance of the market.

The formula for a float-adjusted market-capitalization-weighted index is given by

Float Adjusted Market Capitalization Index value

where I is the index value, k a given asset, K the number of assets in the index, Pk the market price of asset k, Nk the number of issued shares for asset k, Fk the float factor of asset k, and t the time of calculation of the index.

In a float-adjusted market-capitalization-weighted index, the weight of asset k is given by formula can be rewritten as

Float Adjusted Market Capitalization Weighted Index Weight

Fundamental-weighted Index

A fundamental-weighted index is calculated based on specific financial metrics, such as revenue or earnings, rather than market capitalization or price. The weightings of each asset in the index are determined by its financial metrics, so that the companies with the strongest financial performance have the greatest impact on the overall performance of the index.

The formula for a fundamental-weighted index is given by

Fundamental Weighted Index value

where I is the index value, k a given asset, K the number of assets in the index, Pk the market price of asset k, Fk the financial metric of asset k, and t the time of calculation of the index.

In a fundamental-weighted index, the weight of asset k is given by formula can be rewritten as

Fundamental Weighted Index Weight

which clearly shows that the weight of each asset in the index is the value of the fundamental variable of the asset divided by the sum of the values of the fundamental variable of all assets.

Equal-weighted Index

An equal-weighted index is calculated by dividing the total value of the index by the number of securities in the index, and then allocating the same weighting to each security. This method gives each security an equal influence on the overall performance of the index, regardless of its market capitalization.

The formula for an equal-weighted index is given by

Equal Weighted Index value

In an equal-weighted index, the weight of asset k is given by formula can be rewritten as

Equal Weighted Index Weight

Which clearly shows that the weight of each asset in the index, one divided by the number of assets, is constant over time.

Examples of financial indexes

The Dow Jones Industrial Average: an equal-weighted index

The Dow Jones Industrial Average, or DJIA (Dow), was the first index, appearing in 1896. The 30 largest and most prosperous American companies make up the Dow. The experts have carefully chosen these businesses to represent a wide range of industries. Companies with higher prices are given more weight in the Dow. Even though it is the most established and performs similarly to the S&P 500, it is occasionally thought to be less indicative of the entire market.

The S&P 500 index: a market-capitalization-weighted index

S&P 500 – The performance of 500 of the biggest American publicly traded companies is measured. Some people think the S&P 500, which is weighted by market capitalization and has a wider scope, is the best indicator of the American stock market. Because of this, the S&P 500’s average is most significantly impacted by the companies with the highest total market value.

Why should I be interested in this post?

Learning about the calculation of financial indices is important to understand the behavior of an index. It can assist you in managing risk in your portfolio, understanding the overall performance of various markets, and making wise investment decisions. Financial indices can offer insightful data on how various markets, sectors, and economies are performing. Investors can determine whether their investments are outperforming or underperforming the overall market by comparing the returns to the returns of a relevant financial index.

Related posts on the SimTrade blog

   ▶ All posts about Financial techniques

   ▶ Nithisha CHALLA Financial indexes

   ▶ Youssef LOURAOUI Smart Beta strategies: between active and passive allocation

Useful resources

Weight priced index Indice

Equity Indexes Indice

Security market index Indice

Value weighted index Indice

Evolution of indexes Indice

About the author

The article was written in March 2023 by Nithisha CHALLA (ESSEC Business School, Grande Ecole Program – Master in Management, 2021-2023).

Financial indexes

by

Financial indexes

Nithisha CHALLA

In this article, Nithisha CHALLA (ESSEC Business School, Grande Ecole Program – Master in Management, 2021-2023) explains financial indexes, their construction and their use in the finance.

Definition

What is an index? An index can be defined as a measure of a quantity.

An index is a measure of quantity that can be defined as the ratio between the value of the quantity during a current period and its value during a base period. The use of a ration makes it easy to calculate and compare changes in one or more quantities between two given periods. This ratio is often multiplied by 100 or 1,000. Indexes are frequently used in the financial sector to measure the evolution of market prices for a set of financial assets over time. These sets of assets can be defined to represent an asset class, country or geographical zone, or sector of the economy, and provide a comprehensive and accurate overview of the market.

Financial indexes serve as a benchmark for assessing the performance of an investor’s asset portfolio and give investors a way to monitor the performance of a given set of assets. By using financial indexes, investors can gain knowledge of market trends and conditions and make informed investment decisions. Index providers are responsible for creating and maintaining financial indexes.

History

The Dow Jones Industrial Average was first created in 1896 by Charles Dow, a co-founder of the Dow Jones Company, and is widely regarded as the first index. Who is creating the index? The Dow Jones Industrial Average, which included 12 companies at the time that were emblematic of the US Market. Currently, there are 30 companies that make it up even though none of the original 12 companies are still included. As interest in indices increased, financial publications like the Financial Times or exchange owners like the Deutsche Borse in Germany developed their own equity indices, while investment banks took the lead in developing indices for bonds. Since then, numerous other financial indexes have been developed, including the NASDAQ Composite, FTSE 100, Nikkei 225, S&P 500, and others.

Evolution over time

Stock market indexes were initially just simple arithmetic averages of the prices of a small number of chosen stocks; they did not take the entire market into account. The daily averages were first published in the newspapers in the 1800s. Later, they began to use market capitalization weighting, which was well-liked because it assigned weights based on the size of the company. Following that, various indexes based on sectors, nationalities, etc. were assigned. A significant trend recently has been the use of passive index funds and the addition of ESG criteria to the indexes.

Providers of financial indexes

Financial indexes are typically provided by financial data and research firms. As mentioned earlier, though there are several providers in the financial services industry, there are few most prominent index providers – S&P Global, MSCI, FTSE Russell, Dow Jones Indices and Nasdaq. With a combined market share of about 90% for equity indexes, these firms are thought to dominate the world index market.

Index Industry Association (IIA)

The production of indexes has become an industry! And every industry has a professional association. The index industry is no exception. The Index Industry Association was founded in 2012. Some of the founding members are MSCI and S&P Dow Jones Indexes.

As stated on the IIA website, the association mandate is “to educate investors on the attributes and role of indexes within the investment process, to advocate for the interests of index users and providers worldwide, and to push for industry standards of best practice, independence and transparency”.

Composition of an index

The composition of an index is a crucial factor in determining its representation, and it is important for investors to understand the criteria used by the index provider to select the assets included in the index, as well as the weightings assigned to each asset. The composition of an index is designed to represent a specific market or sector, and the index provider selects the assets to be included based on specific criteria, such as market capitalization, liquidity (float), and sector representation.

There are several steps in the process of creating an index. As we all know, index providers use a variety of companies to create the index, but how are they selected? Specific eligibility requirements must be met, such as the size of the business and the industry it belongs to, etc. After the eligible companies have been narrowed down, they are properly evaluated before being included in the index. This evaluation includes looking at the company’s earnings, market capitalization, and other factors. Additionally, they conduct index balancing with regard to various industries, segments, etc. Last but not least the index’s potential market impact is cross-checked as the index stands as a benchmark for the investors to make decisions. Different index providers may have different selection criteria and processes.

The index provider regularly reviews and updates the composition of the index to ensure that it remains representative of the market or sector it is tracking.

For example, the S&P 500 index is designed to represent the performance of the U.S. stock market, and the securities included in the index are chosen based on market capitalization, liquidity, and sector representation. Since each security’s weight in the index is based on its market capitalization, the largest and most powerful corporations have the biggest effects on the index’s overall performance.

Calculation of financial indexes

Once the index provider has chosen the assets to be included in the index based on predetermined criteria, such as market capitalization, liquidity, and sector representation. Then the index value has to be calculated with a specific formula. There are different calculation methods for financial indexes: price-weighted index, market-capitalization-weighted index, equal-weighted index and fundamentals-weighted index.

Classifications of financial indexes

By having a solid understanding of the various classifications of financial indexes, investors can select the most suitable indexes for their investment goals and strategies. Market coverage, calculation method, geographic region, asset class, investment approach, and security type are used to categorize financial indexes.

The criteria for classifying financial indexes include:

  • Asset class: equity, bond, crypto, etc.
  • Geography: US, Asia-Pacific, Europe
  • Sector: Information Technology, Health Care, Financials, Consumer Discretionary, Communication Services, Industrials, Consumer Staples, Energy, Utilities, Real Estate, and Materials.
  • Weighting methodology: price-weighted, market-capitalization-weighted, float-adjusted market-capitalization-weighted, fundamental-weighted
  • Objectives: market representation, risk factor representation

Most popular financial indexes

The Dow Jones Industrial Average

The Dow Jones Industrial Average (DJIA) was established in 1896, is the country’s first stock market index. Thirty large-cap companies that are leaders in their fields are included in this price-weighted index. The index is frequently used as a gauge for the American stock market and the overall economy.    ▶ More about the DJIA index

S&P 500

The S&P 500 index is a market capitalization-weighted index that monitors the progress of 500 large-cap U.S. businesses operating in various industries. It was established in 1957, and many people consider it to be one of the most significant benchmarks for the American stock market. The index is widely used as a benchmark by fund managers and investors and is frequently used as a stand-in for the overall health of the American economy.    ▶ More about the S&P 500 index

Nasdaq Composite

Composed of all the companies listed on the Nasdaq stock market, the Nasdaq Composite is a market capitalization-weighted index. It was founded in 1971 and is renowned for the prominence of technology firms, even though it also includes businesses from the consumer goods, healthcare, and finance sectors. The index is frequently used as a yardstick for growth and technology stock performance.    ▶ More about the Nasdaq Composite index

FTSE 100

The performance of the top 100 companies listed on the London Stock Exchange is tracked by the FTSE 100, a market capitalization-weighted index. Since its creation in 1984, it has gained widespread recognition as the top benchmark for the UK stock market. Companies from the financial, energy, and mining sectors make up the majority of the index, and each company is weighted according to its market capitalization.    ▶ More about the FTSE 100 index

MSCI World

The MSCI World Index tracks the performance of businesses in 23 developed markets around the world, including the United States, Canada, Japan, and Europe. It is a market capitalization-weighted index. It was developed in 1969 and is frequently used as a yardstick for performance in the global equity market. The weighting of each company in the index, which consists of more than 1,600 large- and mid-cap stocks, is determined by its market capitalization.

Health Care Select Sector Index

The Health Care Select Sector Index is based on the companies of the S&P 500’s health care sector. It was established in 1998 with the purpose of monitoring the performance of businesses involved in the health care sector, such as those producing pharmaceuticals, biotechnology, medical devices, and healthcare providers.

Use of indexes in finance

Financial indexes play an important role for market participants like investors, traders, and asset managers. Some of the ways indexes are used in finance include:

Gauges of the market evolution

Indexes can offer insightful information about the state of the financial markets. An index helps to measure the market returns of a given set of securities.

The best part of the stock index is that just by tracking the simple indicator we get a general idea of how the stock market is performing. A stock index clearly shows how the market is performing, or at least the market that it represents, despite the fact that individual stocks may perform differently, making it challenging to determine whether the market is strong or weak.

Benchmarks

Indexes are frequently used as a benchmark to assess the performance of investment portfolios, especially actively managed portfolios.

Proxies for modeling

In academic studies, indexes are used as proxies for the market portfolio to capture systematic risk and to compute risk-adjusted performance.

Portfolio Asset allocation

Because they offer a way to gain exposure to particular asset classes, industries, or geographic areas, indices serve as the foundation for asset allocation strategies.

Risk management

Indexes can assist investors in comprehending the risks related to particular asset classes or geographical areas.

Building of investment vehicles

Exchange-traded funds (ETFs), mutual funds, options and structured products, among others, use indexes as their underlying assets. These investment vehicles make it easy and affordable for investors to become exposed to the index’s performance.

Rebalancing

Some indexes imply frequent and even continuous rebalancing (buying and selling assets). For example, for a fund tracking an equally-weighted index, the fund manager will have to sell assets whose price increased and buy assets whose price decreased.

Change in index composition and impact on asset prices

When an asset is included in an index, its price usually increases as fund managers need to buy it to include it in their portfolio. Conversely, when an asset is excluded from an index, its price usually decreases as fund managers need to sell it to exclude it from their portfolio.

Empirical results confirming these propositions can be found in a study by McKinsey (2004). The prices of the assets included in a financial index may change as a result of changes in the composition of the index over time.

It is crucial to remember that depending on the specifics of the change, the effect of a change in index composition on asset prices may be either short-lived or long-lasting. The effect of a change in index composition on asset prices can also be challenging to forecast because it depends on a variety of variables, such as investor sentiment, fund flows, and market sentiment.

Link with academic research

The performance of a particular sector of the stock market, such as large-cap stocks, small-cap stocks, or a specific sector or industry, is measured by an equity index, a type of financial index.

On the other hand, market factors are factors that account for a significant amount of the variation in stock prices. Market variables include both macroeconomic ones like interest rates and GDP and market-specific ones like market volatility and liquidity.

The relationship between equity indexes and market factors is that changes in market factors can have an impact on equity index performance, and equity index performance can be influenced by market factor changes. For instance, adjustments in interest rates may have an effect on the performance of the stock market as a whole and, consequently, on the performance of an equity index that monitors the stock market. Factor-based indexes that seek to capture the performance of particular market factors, such as value, growth, and momentum, have been developed as a result of research into the effects of market factors on equity indexes. These factor-based indexes can be employed to examine the effects of market factors on the performance of equity indexes and to base investment choices on the exposure to market factors.

Why should I be interested in this post?

I frequently come across news-related stocks, bonds, and indices in publications like newspapers, financial journals, and business magazines. We require a fundamental understanding of indices in order to even understand what is happening in the business world. It’s also crucial to have a thorough understanding of markets and financial indices because we need to comprehend these financial indices in order to assess a company’s performance and compare it to previous years.

Related posts on the SimTrade blog

   ▶ All posts about Financial techniques

About financial indexes

   ▶ Nithisha CHALLA Calculation of financial indexes

   ▶ Nithisha CHALLA The business of financial indexes

   ▶ Nithisha CHALLA Float

Examples of financial indexes

   ▶ Nithisha CHALLA The DJIA index

   ▶ Nithisha CHALLA The S&P 500 index

   ▶ Nithisha CHALLA The Nasdaq index

Useful resources

Insee Indice

Russel How are indexes weighted?

Financial Index Industry Presentation of the association

Index Industry Association Presentation of the association

Marc H. Goedhart and Regis Huc (2004) What is stock index membership worth? McKinsey & Company.

About the author

The article was written in March 2023 by Nithisha CHALLA (ESSEC Business School, Grande Ecole Program – Master in Management, 2021-2023).

My experience as a Risk Advisory Analyst in Deloitte

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My experience as a Risk Advisory Analyst in Deloitte

Nithisha CHALLA

In this article, Nithisha CHALLA (ESSEC Business School, Grande Ecole Program – Master in Management, 2021-2023) shares her experience as a Risk Advisory Analyst in Deloitte.

About the company

Deloitte is one of the Big Four accounting firms along with EY (Ernst & Young), KPMG, and PricewaterhouseCoopers (PWC). It is the largest professional services network (with teams in different countries working together) by the number of professionals and revenue in the world, headquartered in London, England. The firm was founded by William Welch Deloitte in London in 1845 and expanded into the United States in 1890. Deloitte provides audit, consulting, financial advisory, risk advisory, tax, and legal services with approximately 415,000 professionals globally. In fiscal year 2021, the network earned a revenue of US$50.2 billion in aggregate. Additionally, a few of Deloitte’s largest customers as of 2021 includes Morgan Stanley, The Blackstone Group, Berkshire Hathaway, etc.

Logo of Deloitte.
Logo of Deloitte
Source: Deloitte.

As a risk advisory analyst, I had the opportunity to read a lot of surveys that Deloitte conducted on an annual basis to assess work ethics, strategy and their influence on a particular business line. In order for individuals to relate, these polls also provide an overview of the global standing in the relevant business sector. The 11th edition of the Global Risk Management Survey states that despite the relatively stable global economy, risk management is currently dealing with numerous significant impending risks that will force financial service institutions to reconsider their traditional methods. The company also maintains that risk management must be integrated into strategy so that the institution’s risk appetite and risk utilization are important factors to consider.

My experience as a Financial Risk Advisory Analyst at Deloitte

My hands-on experience with risk management and its applications kick-started with my first profile in the Anti-Money Laundering division after graduation as a Financial Risk Advisory Analyst at Deloitte USI (Deloitte USI is a division of Deloitte US that serves customers of the US member firm and is physically located in India.). In this project, I worked for an international bank to audit and assess the company’s customer risk.

My responsibility at work

As an employee in the Risk Advisory department at Deloitte, I provided a host of advanced services to an international bank. I conducted Enhanced Due Diligence for the client’s high-risk and high-net-worth customers through sources of origin and transactions that exhibit irregular behavior. A large part of my work was to minimize or optimize risk, in maintaining the highest standard of financial understanding, I undertook regular risk assessments. The nature of my tasks has brought me close familiarity with numerous domains, highlighting clientele involvement in economically sensitive industries and geographies all over the world.

The work involved holistic net-worth assessment for high-profile customers in accordance with their diversified financial portfolios. The team starts by researching the client and using public records to confirm any criminal history. The team then determines the customer’s net worth by conducting a thorough analysis of the client’s varied sources of income, including a family trust, an inheritance, self-employment, and stock investments. Additionally, the team examines the transactions to look for any potential signs of money laundering.

The whole process is carried out in accordance with the three stages:

  • Placement
  • Layering
  • Integration

The first step in money laundering is depositing illegal funds in financial institutions to make them appear legitimate. This entails splitting up larger sums of money into smaller, less noticeable amounts, transporting cash across borders to deposit the money in foreign banks, or purchasing pricey items like fine art, antiques, gold, etc. Once the money has entered the financial system, it is moved around, or layered, from one place to another in an effort to conceal criminal activity.

For instance, buying an antique item with the money and selling it later to fund the establishment of a holding company or non-financial trust. These financial entities, which are typically corporations or limited liability companies (LLCs), hold the controlling stack of their subsidiary companies and, as a result, oversee the management of child companies without getting directly involved in their day-to-day management.

Another example would be by locating the holding company in a region with a low tax rate. These controlling companies are simple to establish and can significantly reduce the tax burden of the entire corporation. If a child company declares bankruptcy, the holding company, which may hold additional child companies or portions of child companies, is shielded from the loan creditors. After the money appears legitimate, the money is integrated into the system to gain profit. At this stage, identifying black money is very difficult for the bank system.

My missions

My job has broadened the scope of my leadership abilities, and I have led a group of five analysts for a quality check to ensure that projects with strict deadlines are completed on time and to the standard of quality that clients have come to expect from the company. I’ve received several spot awards during my time at Deloitte for my willingness and capacity to go above and beyond.

By establishing a scope to coordinate with on-site teams and executives across geographies, I have gained significant international exposure in the comparatively brief time I have spent at Deloitte. Additionally, I’ve had a profound introduction to the procedures that enable experts to identify elements that pose risks to the regular functioning of enterprises, and thus eliminate and streamline the same.

What I have gained from the job

The following points mentioned below are a brief sum-up of what I learned through my full-time role in the project:

Tax obligations in various jurisdictions

The tax is calculated for a company based on the base location irrespective of how money is flowing into the company.

Different financial entities

The functioning, policies, and structure are different for different entities like LLCs, LLPs, holding companies, non-financial trusts, etc.

Beneficial Ownership

One company can have multiple form of owners, like joint ownership, proprietorship, or partnership, and in a such complex model, how beneficial ownership is decided.

Required skills and knowledge

The hard skills I needed to make presentations or scatterplots when I first started working included knowledge of Money Laundering, Microsoft Suite and Excel. Since the projects associated with these business lines are typically enormous, having solid soft skills will make it easier to manage them. Good soft skills, compliance, teamwork, and cooperation are necessary on an individual level.

Key concepts

I developed below key concepts that I use during my job.

Know your customer (KYC)

Know Your Customer (KYC) can also refer to Know Your Client. Financial institutions are protected by Know Your Customer (KYC) regulations from fraud, corruption, money laundering, and financing of terrorism. When opening an account and on an ongoing basis, KYC checks are required to identify and confirm the client’s identity. In other words, banks need to confirm that their customers are actually who they say they are.

Due Diligence

It refers to the procedures employed by financial organizations to gather and assess pertinent data regarding a customer. It seeks to identify any potential risk associated with doing business with them for the financial institution. The procedure entails assessing public data sources, including firm listings, private data sources from third parties, or government sanction lists. Meeting Know Your Customer (KYC) standards, which differ from nation to country, involves conducting extensive customer due diligence.

Anti-Money Laundering (AML)

The network of rules and norms known as anti-money laundering (AML) aims to expose attempts to pass off illegal money as legitimate income. Money laundering aims to cover up offenses like minor drug sales and tax evasion as well as public corruption and funding of terrorist organizations. AML initiatives seek to make it more difficult to conceal the proceeds of crime. Financial institutions need rules to create regulated customer due diligence plans to evaluate money laundering risks and identify questionable transactions.

Why should I be interested in this post?

I believe that this post’s description of anti-money laundering, a significant business sector of Risk and Financial Advisory, might be very helpful to those interested in pursuing professions in finance. It will help them bridge the gap between real life work experience and theoretical knowledge. My understanding is that this article also provides a quick overview of the auditing and RFA (risk and financial advisory) work environments at Deloitte, one of the Big Four organizations.

Related posts on the SimTrade blog

   ▶ All posts about Professional experiences

   ▶ Basma ISSADIK My experience as an M&A/TS intern at Deloitte

   ▶ Anant JAIN My internship experience at Deloitte

   ▶ Pierre-Alain THIAM My experience as a junior audit consultant at KPMG

Useful resources

Deloitte

About the author

The article was written in January 2023 by Nithisha CHALLA (ESSEC Business School, Grande Ecole Program – Master in Management, 2021-2023).