Equity Investments I
Reading 37. Security Market Indices
Learning Outcome Statements
h. describe types of equity indices;
i. describe types of fixed-income indices;
j. describe indices representing alternative investments;
k. compare types of security market indices.
CFA Curriculum, 2020, Volume 5
Subject 4. Different Types of Security Market Indices
There are different types of equity indices.
A broad market index represents an entire given equity market. Examples include the Russell 3000, the Wilshire 5000 Total Market Index, etc.
Local indices of individual countries lack consistency in sample selection, weighting, or computational procedures. Global equity indexes are created to solve this comparability problem. A multi-market index represents multiple security markets. For example, the Dow Jones World Stock Index includes 2,200 companies in 33 countries.
A sector index measures the performance of a narrow market segment, such as the biotechnology sector. It can be used to determine if a portfolio manager is good at sector allocation or not. It can also be used to track the performance of sector-specific funds.
Style strategies focus on the underlying characteristics common to certain investments. Growth is a different style than value, and large capitalization investing is a different style than small stock investing. A growth strategy may focus on high price-to-earnings stocks and a value strategy on low price-to-earnings stocks. Style indices are created to represent such securities.
Fixed Income Indices
The creation and computation of bond-market indices is more difficult than that for a stock market series.
- The universe of bonds is much broader than that of stocks.
- The universe of bonds is changing constantly because of new issues, bond maturities, calls, and bond sinking funds.
- The volatility of prices for individual bonds and bond portfolios changes because bond price volatility is affected by duration, which is changing constantly.
- Pricing individual bonds is difficult compared to the current and continuous transactions prices available for most stocks used in stock indexes.
All bond indices indicate total rates of return for the portfolio of bonds, including price change, accrued interest, and coupon income reinvested. They are relatively new and not widely published. Most indices are market-value weighted.
Bond indices can be categorized based on their broad characteristics, such as type of issuer, currency, maturity, and credit rating. For example, there are different indices for government bonds, high-yield bonds, corporate bonds, and mortgage-backed securities.
There are five major commodity sectors: energy, grains, metals, food and fiber, and livestock.
A commodity price index is a fixed-weight index of selected commodity prices, which may be based on spot or futures prices. It is designed to be representative of the broad commodity asset class or a specific subset of commodities, such as energy or metals.
- Different commodity indices have different weighting methods, which result in different risk and return profiles.
- A commodity index may track commodities directly, or indirectly by tracking futures contracts for certain commodities. For example, commodity indices may track energy products or currencies, or may tracks futures contracts in either of those. For a commodity index that consists of futures contracts on the commodities, the index returns are affected by factors such as the prices of the underlying commodity, the risk-free interest rate, and the roll yield.
Real Estate Investment Trust Indices
Types of real estate indices include appraisal indices, repeat sales indices, and REIT indices which track the performance of publicly traded REITs.
Hedge Funds Indices
There are many indices that track the hedge fund industry. Since hedge funds are illiquid, heterogeneous, and ephemeral, it is really hard to construct a satisfactory index.
Funds' participation in an index is voluntary, leading to self-selection bias because those funds that choose to report may not be typical of funds as a whole.
The short lifetimes of many hedge funds means that there are many new entrants and many departures each year, which raises the problem of survivorship bias. If we examine only funds that have survived to the present, we will overestimate past returns because many of the worst-performing funds have not survived, and the observed association between fund youth and fund performance suggests that this bias may be substantial.
When a fund is added to a database for the first time, all or part of its historical data is recorded ex-post in the database. It is likely that funds only publish their results when they are favorable, so the average performances displayed by the funds during their incubation period are inflated. This is known as "instant history bias" or "backfill bias."