Types of equity indexes

What are equity indexes for?

An equity index tracks the value of a set of shares. Uses of equity indexes fall into three groups: following market risk and return, evaluating and benchmarking portfolios and managers, and building index funds and other products that track them.

An index usually has a fixed number of index constituents , each represented by its common shares. Their prices, combined under a weighting method (by market capitalization, by price or by other factors), give the index value. How those weights and returns are calculated is covered in Quantitative Methods (see price-weighted and equal-weighted indexes).

Most broad-based indexes hold a market’s largest listed companies, adjusted for market float and weighted by market capitalization. That approach is float-adjusted market-cap weighting . Price weighting and fundamental weighting are more common in narrower indexes.

Equity indexesmost are float-adjusted, cap weighted

• Broad-based Memorize a market's largest firms; tiered by size
  • Composite more than 90% of the market's value
  • Large, mid and small cap
• Sector Memorize one industry
• Theme Memorize a trend across industries: consumption, infrastructure, religious-law or environmental, social and governance (ESG) screens
• Alternative weighting Memorize
  • Equal weight 1/N each
  • Fundamental factors revenue, earnings, dividends, book value, quality scores
• Multi-market Memorize several countries, a region, a development level or the world; return includes currency

Broad-based indexes and size tiers

A broad-based index holds a market’s largest listed firms and is usually split into size tiers : large, mid and small cap. The most comprehensive is the composite equity index , which typically includes shares making up more than 90% of a market’s value and is split into size indexes.

A large-cap index alone is not a composite. It leaves out the smaller companies.

Sector and theme indexes

A sector index holds companies in one business. Sector indexes exist because broad cap-weighted indexes are dominated by the largest companies (often those whose shares have risen most) and by concentrated industries. They let investors and companies compare competitors, and let funds offer exposure to one industry rather than one company or the whole market.

A theme index follows an investor trend that cuts across industries and sizes. Examples are companies selling mainly to domestic consumers, owners of long-lived infrastructure assets, companies screened for compliance with Islamic law, or companies screened on environmental, social and governance principles.

An environmental, social and governance (ESG) index is commonly built in steps (this is one common approach).

1. Start from a parent index.
2. Exclude companies in certain activities (for example certain weapons, thermal coal or tobacco) and companies that breach recognized global standards of conduct.
3. Rank the rest by an ESG score and drop the lowest-scoring portion (say, the bottom 20%).
4. Weight what is left by float-adjusted market capitalization.

Alternatively weighted indexes

Some indexes keep a broad index’s members but change the weights, because cap weighting tilts toward the largest companies and those whose prices have already risen. That is alternative weighting .

In an equal-weighted index each of N constituents gets 1/N. A 40-share index gives every company 2.5% (1 ÷ 40), whether it is 11% or 0.4% of the cap-weighted version.

$$w_i = \dfrac{1}{N}$$

fundamental factors are measures other than market capitalization, such as revenue, earnings, dividends or book value. factor-based investing selects and weights shares by factors believed to drive performance, such as earnings growth or a strong balance sheet. That demand created many alternatively weighted indexes.

For example, a quality index scores each company on profitability (return on equity), earnings stability and leverage (debt to equity), using a statistical process. The score adjusts each company’s cap weight, companies with low scores are dropped, and the best scores get more weight than in the parent index. Factor weights can combine several factors and can start from cap weights. The factor models behind such indexes come in Learning Module 12 (see the capital asset pricing model (CAPM) and factor models).

Multi-market indexes

A multi-market index combines national markets: several countries, a region, a level of economic development (developed or emerging markets) or the whole world. Funds tracking them let investors reduce a home bias (the habit of holding mostly local shares) with a product traded on their own exchange.

Such a fund’s return, in the investor’s currency, has two parts: the foreign index return and the currency move.

$$R_{home} = (1 + R_{index})(1 + R_{currency}) - 1$$

Which index is the right benchmark?

The one that matches what the portfolio holds: the same markets, the same size range, the same weighting approach and the same theme. This is the benchmark choice .

Take a Canadian foundation that runs a portfolio of 45 large companies from many countries that pass environmental, social and governance screens.

• A Canadian large-cap ESG index misses the global reach.
• A global ESG composite index adds thousands of small companies the foundation never buys.
• A global large-cap ESG index fits.

Exam tip Check four things: where (one country or many), how big (large cap or all sizes), how weighted (cap, equal, factor) and any theme or screen. A benchmark that differs on any of them makes a manager look better or worse for the wrong reason.

Sort indexes by type, then match four portfolios to their benchmarks.