Equity Indices

What are “Equity Indices”?

Equity indices are an aggregate of statistical values formed by having a grouping of securities that are priced to a base value at a specific date. An equity index is a group of securities that are combined together, in order to gain insight into the price appreciation or total return over a specific time period.

Equity indices are used to track the overall movement or performance of various securities markets. The major US equity indices are the Dow Jones Industrial Average (DJIA), S&P 500 (most widely followed), Nasdaq Composite, and Russell 2000. The major equity indices outside the US are the FTSE 100 (UK), Dax (Germany), CAC (France), and Hang Seng (Hong Kong).

Equity indices can also be industry or sector-specific (e.g. consumer goods, energy, finance, technology), style-specific (value or growth index). They can also be total return indices (so including price return plus dividends paid), or multi-market indices. Equity indices can be calculated in various different ways – market value weighted, price weighted, equal weighted and fundamentally weighted.

Equity Indices – Four Methodologies

‘Market value’ or ‘capitalization weighted’ index (MWI): this is the most common methodology and is based on the size of each individual company. In a MWI, the weight of each constituent company or security is determined by dividing its market capitalization (or value) by the total value of all the securities in the index. Therefore the largest constituent companies by value (i.e. market capitalization) have the largest influence on the value of the overall index. The most common examples of such an index are S&P 500, NASDAQ, and FTSE 100 – which all use this type of methodology.

‘Price weighted’ index (PWI): these were the first commonly used equity indices. However, they are rarely used today and have been superseded by other methodologies. Here, the weighting of each individual stock is simply equal to the actual individual stock price divided by the sum of all the companies’ stock prices within the index.

In such an index (e.g. DJIA), stocks with higher absolute stock prices are accorded higher weighting than stocks with lower prices. The individual company’s size or the number of shares it has outstanding does not contribute to the index weighting.

Consequently, stocks with higher prices (e.g. $78 per share)  have a greater impact on the movements or changes in such an index than stocks with lower prices (e.g. $12 per share). Therefore, if one of the higher priced stocks in the index has a large price increase, the index is more likely to increase even if the other stocks in the index with the lower prices decline in value at the same time.

Equally weighted index (EWI): in such indices, all companies, regardless of their size and stock price value, have the same level of influence on the index. The calculation for each weighting is simply 1/N, with N being the number of companies within the index. An example is the S&P 500 Equal Weighted Index, which is a derivative of the S&P 500.

Here all stocks have an equal impact on the movement of the index, irrespective of the number of shares outstanding, or the price of any particular stock.

Fundamentally weighted index (FWI): here, the weightings are based on the fundamental metric(s),  not just price or just value but things such as sales, earnings, book value, cash flow, dividend yield or all of them, and these metrics drive what is known as smart beta strategies and smart beta funds.

Market Value Weighted Index, Example

In the workout with reference to a market value or capitalization weighted index, we assume that a stock market index (in this case, D&B 100) has five constituent companies. From the information given below, the total market value of this stock market index is computed.

What is notable from this workout is that company EYE has a weighting of 48.3% in the index (US$200m as a % of the total index US$414m market cap) and has the highest market capitalization. Consequently, it will have a greater impact on the movements or changes in the D&B stock market Index, even if its stock price (US$80) is lower than company ABC’s stock price (US$150).