Posted: August 30, 2013
All about the index
What is it, really?Michael Caplan
- Sector Segmentation Many providers of diversified indexes segment their primary indexes into sector subsets. However, the definitions of sector vary, with different classification schemes in use. The Global Industry Classification Standard (GICS) was developed jointly by Morgan Stanley Capital International and Standard & Poor’s and forms the basis for each of these firms’ index sector distinctions. GICS is composed of 10 sectors, each of which includes one or more industry groups drawn from the GICS list of 24 such groups. The North American Industrial Classification System (NAICS) and its ancestors such as the Standard Industrial Classification (SIC) system are widely used by economists, the Securities and Exchange Commission and some other index providers. This system defines more than 400 individual industries in the economy, each of which can be grouped into one of 24 different sectors. An investor looking to use indexes for a sector rotation strategy should consider the classification systems used by the indexes.
- Market Capitalization and Float In the context of indexes, there are no universally applicable definitions for large-cap, midcap or small-cap. A company that is listed as small in one provider’s universe may be considered medium or large in another’s. That’s because some index providers view only market value when making their groupings, while others may adjust their categorizations to reflect variances in company age or maturity, business factors and growth rates. Float is another factor that leads to variation. Some index providers consider all shares equally when assessing the size of a company. Others consider only the value of shares that can be publically traded, a statistic known as the free float. For example, a company with a large number of shares held by insiders who are bound by trading restrictions will have a much smaller free float than a similar-sized company with no stock subject to trading restrictions.
- Weighting is the practice of adjusting each constituent’s contribution to the index to reflect its relative size in the index. Weighting is most typically based on price per share or total company size. In price weighting, a stock whose share price is $20 will have twice the influence on the index as a stock whose share price is $10. In capitalization weighting, a constituent whose total market value is twice as great as another’s would have twice the influence on the index. The DJIA, for example, uses price-weighting factors in its calculations, while the S&P 500 uses capitalization-weighting factors.
- Company Domicile Major stock indexes in the United States all reflect pricing action on US stock exchanges. But some indexes (such as the S&P 500) include companies based outside the United States who list their shares here, while others (such as the Dow and Russell) limit their constituent universes to US-domiciled firms.
- Index Turnover Some firms follow fixed schedules for reevaluating their constituent lists and making changes to those lists. Russell, for example, undertakes this kind of index revision once each year, at the end of June. Others respond more fluidly. Standard & Poor’s analysts continually monitor their index constituents and make changes to their indexes as conditions warrant, sometimes as often as daily or weekly.
- Investability and Tracking Error While it may be impossible to invest directly in any index, asset managers can create portfolios that are intended to replicate index performance. Along the same lines, index architects can design benchmarks that simplify the process of replication for portfolio managers. One important tool for measuring how well a portfolio tracks an index is tracking error. In its simplest statistical form, tracking error is the arithmetic difference between portfolio returns and benchmark returns; the smaller the difference, the closer the manager is to the benchmark.
Investment indexes are complex devices that can be invaluable tools when used properly, or hazardous when used inappropriately. And while you cannot invest directly in any index, you can find investments that mirror the performance of a specified index. Many investors find these investments ideal for certain purposes. I can help you get a better understanding of indexes and also find suitable index-based investments
Michael Caplan is a Financial Advisor and Associate Vice President with the Global Wealth Management Division of Morgan Stanley in Denver. He can be reached at Michael.Caplan@morganstanley.com or (303) 595-2094.