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Market Index Explained: Guide to Security Market Indices
FINANCE & FINANCIAL MARKETS
1. What is an Index? 1:49
2. What Do We Use Indices For? 3:38
3a). Different Types of Indices: Price vs Total Return 4:47
3b). Different Types of Indices: Weights 5:54
3c). Different Types of Indices: Underlying Securities 10:48
4. Rebalancing and Reconstitution 13:35

1.WHAT IS AN INDEX?
It’s a numerical Value
...generated, published and promoted by a private organisation

This value is calculated from Market Prices of the index's Constituents

Constituents are made up of an security market, asset class, or market segment

Thus the index can reflect the value or performance of a particular security market, asset class or market segment

E.g. If the S&P 500 Index rises 2%, then that represents a 2% increase, of the 500 stocks that make up the S&P 500 equity Index

Index Examples:
Dow Jones Industrial Average
Nikkei Stock Average
MSCI All Country World Index
Barclays Capital Global Aggregate Bond Index
FTSE EPRA/NAREIT Global Real Estate Index
HFRX Global Hedge Fund Index

2. WHAT DO WE USE INDICES FOR?

Measure a Market’s Return
...or Just Measure Market and Investor Sentiment
To Use the Index as an Investment Performance Benchmark Provide a Model Portfolio, or a Portfolio Selection Basket, for funds
e.g. ‘Index Funds’ or ‘Large-Cap Funds’
For Quantitative Functions
e.g. to assist in calculating beta, expected returns or risk-adjusted returns

3. DIFFERENT TYPES OF INDICES
a) ‘Price’ vs ‘Total Return’ Indexes

'Price' Index:
Calculated using on the market prices of the underlying, constituent securities

'Total Return' Index:
Calculated by ALSO including cash flow from the constituent securities, e.g. dividends and interest

3. DIFFERENT TYPES OF INDICES
b) Weighting Methods
How each constituent security impacts the final index value is dependent on its Weight in the Index.
There are a number different weighting methods

‘Price-weighted’ Index:
Each security has an equal number of shares/units in the index
e.g. 1x share of Apple, 1x share of Exxon Mobil, etc
Thus, higher priced securities have greater weight, when shares/units are held equal
i.e. ‘Price-weighted’

‘Market Cap-weighted’ Index:
Each security's index weight should represent their actual % of total market value
e.g. 30x shares of Apple (if 30% of market), 5x shares of T-Mobile (if 5% of market), etc
Thus, larger market cap securities have greater weight
i.e. ‘Market Cap-weighted’

‘Equal-weighted’ Index:
Each security's index weight is the same and should have an equal dollar value in the index
e.g. 10x shares of Apple (if AAPL @ $50), 20x shares of Netflix (if NFLX @ $25), etc
Thus, smaller market cap securities have greater weight
This methods means the Index Return is just the avg return of constituents

Others:
Float-Adjusted Index Weights:
e.g. ‘Market-float Weighted’ Index or a ‘Free Float’ Index
Fundamental Index Weights:
e.g. ‘Revenue’, ‘Earnings’ or even ‘GDP’ weighted indexes

3. DIFFERENT TYPES OF INDICES
c) Underlying Securities
There’s virtually no restriction on the groups of underlying securities that make up the constituents of an index
...But the Key Ideas are:

It’s not about ‘restrictions’ on what can be an index,
it’s about ‘competition’ and ‘relevance’ to make the index popular & adopted.
To have mass adoption an index must represent, or include, a material commonality or grouping useful/valuable for investors

Equity Market Indices:
Broad Market, e.g. the whole market
Multi Market, e.g. multiple countries
Sector, e.g. technology
Style, e.g. large-cap

Alternative Asset Indices:
Real Estate Indexes
Commodity Indexes
Hedge Fund Indexes

Fixed Income Indices:
Country, or Region Indices
Sector Index
Type of Issuer Index, e.g. Corporate or Government
Maturity

4. REBALANCING AND RECONSTITUTION
An Index is NOT static.
They are frequently updated, e.g. quarterly, annually

Rebalancing:
Update the Weights of the Index Constituents
e.g. An Equal-Weighted Index needs rebalancing as weights become unequal over time

Reconstitution:
Updating the Constituents, i.e. Adding and deleting them
e.g. ASX200 has companies fall out of (and rise into) the top 200 market cap stocks


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