The business of financial indexes

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).

Calculation of financial indexes

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

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).