1、1,Introduction to Indices and Mutual Funds,Week 2: Chapter 2, 4,2,Market Indices (Chapter 2),What is an index? Why are stock market indices important? What are the difference ways in which the indices are calculated? What is the difference between some common indices?,3,Equity Indices,An equity inde
2、x can be viewed as a portfolio of stocks. Different indices differ in the way this portfolio is created. Why is an equity index useful: 1. It is a convenient way of keeping track of the market as a whole. 2. It serves as a benchmark for measuring the performance of active fund managers. 3. It can be
3、 a good investment strategy- for example, passively investing in the S&P 500 over the last 10 years would have helped you beat the vast majority of active fund managers.,4,Different Ways in which an Index is Constructed,1. An index may differ in the choice of stocks. For instance, the DJIA has 30 bl
4、ue-chip stocks, while the Wilshire 5000 has about 7000 stocks. You may also have indices that are based on size, sector, country, or investing styles. 2. An index can differ in the way the weights of each stock in the index is determined. For example, the weights may be determined by the price of th
5、e each stock in the index (price-weighted index), or by the market capitalization of the stock, or may be kept fixed.,5,Weights,1. Price weighted: DJIA The weight of each stock in the index depends on the price of the stock. 2. Capitalization weighted: S&P 500, Wilshire 5000 The weights depend on th
6、e capitalization, or the size of the company. The greater the market cap of the stock, the greater its weight. 3. Equal weighted: Wilshire 5000 equal weighted (not often used. Each company is equally weighted. Thus, the index consists of 100 stocks, then the weight of each stock is 1%.,6,Price-Weigh
7、ted Index (1/2),The weight of each stock is the ratio of its price to the sum of the prices of all stocks that are included in the index. This is equivalent to stating that we buy 1 share of each stock in the index. E.g Suppose the index comprises only of 2 stocks: KO and PEP. If price of KO is 45 a
8、nd the price of PEP is 50, then the weight of KO will be 45/(45+50) = 0.474, and weight of PEP is 0.526 . How will we define the index value. One way is to use the average, (45+50)/2=47.5. Of course, this is arbitrary and we can normalize it to 100, by dividing by an arbitrary divisor “d”. Example:
9、Suppose we want the index to be 100. Then, (45+50)/(d) = 100. Thus, if we use d=0.95, we would start our index at a level of 100. Now, suppose the next day, KO=50, PEP=52. The new index level now will be (50+52)/0.95=107.3684.,7,Price-Weighted Index (2/2),The most famous example of a price-weighted
10、index is the Dow Jones Industrial Average. Two problems need to be sorted out whilst constructing a price-weighted index. How does one handle: 1. Splits or stock dividends. 2. Change in the composition of index. After either of these events the index level must be unchanged. For example, if the inde
11、x level was at 100 before a change in the composition, it should be at 100 after the change in the composition. This implies that the divisor (0.95 in the previous example) will have to be changed. For example, suppose you replaced PEP in the KO-PEP index of the previous example with BUD with a pric
12、e of 47. The divisor would have to be changed from 0.95 to 0.92 so that (45+50)/0.95 = (45+47)/0.92=100 keeping the index unchanged.,8,Cap-Weighted Index,The weight of each stock is the ratio of its market cap to the total market cap of the index. Example of S&P 500 (2 Jan 2002): Market Cap of all s
13、tocks = $10.526 trillion. Market Cap of the largest stock (GE) = $406 billion. Therefore, the weight of GE in the S&P 500 is 406/10526=3.86%. Market Cap of the smallest stock (US Airways) = $429 million. Therefore, the weight of U in the S&P 500 is 0.429/10526=0.0041%. In a cap weighted index, much
14、of the movements of the index will be determined by price movements in the largest stocks. Price movements in the smallest stocks in the index will typically have negligible effect on the index.,9,Equal-weighted,The weight of each stock in the index is the same. Thus, if there are n stocks, the weig
15、ht of each stock is (1/n). Thus, if there are 100 stocks in the index, the weight of each stock will be 0.01. Example: If you construct an equal weighted index of two stocks, KO and PEP, the weight of both KO and PEP will be 0.5. The problem with equal weighted indexes is that it is difficult to rep
16、licate with a real stock portfolio, as the every stock price movement leads to the portfolio having to be re-balanced. Example: Suppose you have an equal-weighted portfolio of two stocks, KO and PEP. Assume you invest a total of $100, with $50 in each of these two stocks. Now KO increases in price b
17、y 10%, while PEP remains the same. Your investment in KO is now $55, while your investment in PEP is still $50. To make your investment in KO and PEP equal, you will have to sell $2.50 of KO stock, and use that money to buy $2.50 of PEP stock.,10,Updating an Index, When You Know the Weights,Consider
18、 an index of N stocks. The weight of stock “i” is wi. Suppose on 1/1/2002, the index is at I(t), and each stock has a price of Pi(t). The next day each of the stock price moves to Pi(t+1). What should be the new index level? We can compute the new index level by noting that the index return is the s
19、ame as the return on the portfolio of N stocks. The return of each stock is Ri= Pi(t+1)- Pi(t)/ Pi(t). The portfolio return is SUM(wi Ri). If the new index level is I(t+1), then the return of the index is I(t+1)-I(t)/I(t) = SUM(wi Ri). Thus, from the portfolio return we can calculate the index value
20、.,11,Updating an Index, When You Know the Weights,An Example. Suppose we construct an index of two stocks, KO and PEP. The weights of KO and PEP are 0.474 and 0.526, respectively. The index level is at 100, and the price of KO=45, PEP=50.The following day, KO=50, PEP=52. Thus, the return of KO is (5
21、0-45)/45=0.1111%, and that of PEP is (52-50)/50=0.04%. The return of your portfolio of two stock is (0.474x0.1111+0.526x0.04) = 0.0737. What is the new index level? If we denote the new index level as I, then the index return is (I-100)/100. But this should be equal to 0.0737.Therefore, (I-100)/100
22、= 0.0737. So the new index level is 107.37.,12,Examples of Different Indices,With a few exceptions (notably the Dow), most indices are now capitalization weighted, including the S&P 500, and almost all the Wilshire indices. Thus, the differences between indices are largely due to differences in the
23、stocks that comprise the index. Over time, many different indices have been introduced to give to represent different sub-sets of the markets. For example, indices have been constructed to represent companies of different sizes (large, midcap, small), or that fall into different style categories (va
24、lue vs. growth), or different industry sectors (utilities, internet, etc).,13,Dow Jones Industrial Average (DJIA),First started by Charles Dow in 1896. Number of stocks: 30. The composition does not change very frequently. In particular, the DJIA included Microsoft and Intel into the index only on N
25、ovember 1, 1999. The divisor (used to calculate the index level) has often changed over time; the current divisor is 0.1445.,14,S&P 500 (1/3),The S&P 500 is probably the second most famous index after the Dow (although its market impact is definitely greater than the Dow as about $700 billion of ind
26、ex funds is directly tied to this index) Number of stocks: 500 US stocks, chosen by the S&P Index Committee (probably based on factors like size, liquidity, or industry). Weights:by market capitalization. Total market value (1/2/2002): $10.527 trillion,15,S&P Weights (1/2/2002) 10 Largest Firms,16,S
27、&P 500 (3/3),The 10 largest firms had a combined weight of 24.94% as of January 2002 (23% as of November 1999). The bottom 250 firms had a combined weight of 10.47% (8.32% on 11/99). The total weight in the 19 firms with market caps of less than $1.5 billion is 0.19%. The total weight of firms below
28、 $2 billion is 0.54% (38 firms). The weighted average market cap is $107 Billion. Thus, much of the movements in the S&P 500 is determined by the large firms, in particular, by large, growth stocks.,17,Dow vs. S&P 500 Last 5 Years,18,Wilshire 5000,A very broad total market index. Created in 1974, wi
29、th data from 1971. Number of stocks : 6,500 stocks (of the about 12,000 US public firms). Weights: by market capitalization (earlier, also had an equal weighted index). Total market value (12/31/99) = $15.8 trillion. Percentage of total US capitalization: Almost 100% of total US capitalization. Beca
30、use of its breadth, the Wilshire has a much higher weight on small caps as compared with the S&P 500. About 10% of the index is in small-caps with capitalization as compared with less than 0.5% for the S&P 500.,19,Other Wilshire Indices,There are many other Wilshire indices (see http:/). These indic
31、es are useful to give us a quick idea of the market movements. For example: which group of stocks did particularly well (badly) last year? We can answer this question by simply observing the returns on the different Wilshire indices (see next slide.) Clearly, large, growth stocks did the worst. The
32、best performance was in the smallest micro-cap stocks (bottom half of the Wilshire 5000) and small, value stocks.,20,Wilshire Index Returns,21,Introduction to Mutual Funds,What is a fund? How do we classify funds? Open vs. ClosedActive vs. Passive Fund Styles/Objectives Mutual Fund/Hedge funds How t
33、o read the annual report of a fund?,22,Classifications: Open vs Closed (1/3),An open-ended fund redeem or issue new shares at their net asset value on a continuous basis over the life of the fund. A closed-end fund issues shares only at inception of the fund, and then manages the dollars raised thro
34、ugh the life of the fund. The shares of the fund are listed on an exchange that allows investors to buy/sell into the fund. Because the open-end fund allows issuance or redemption, the “price” of the fund is always it NAV (except for fees). On the other hand, the price of a closed-end fund can diffe
35、r from its NAV.,23,Open vs. Closed End Funds (2/3),Often, closed-end funds trade at a discount to their NAV. Discounts of 5-15% are not uncommon. A few funds, notably country funds, have also traded at a premium. These discounts also vary over time. To eliminate the discount, many closed-end funds l
36、imit the life of the fund, or explicitly state that they will buy back stock in the fund. Occasionally, large investors and hedge funds have attempted to arbitrage this discount by buying large quantities of shares and forcing the fund to open-end. Finally, because of this discount/premium, the retu
37、rn on an investment on a closed-end fund be can different from the change in its NAV.,24,Open vs. Closed End Funds (3/3),It has been argued that a reason for creating a closed-end fund instead of an open-ended fund is because: (1) a closed-end fund can be fully invested, while an open-ended fund may
38、 have to keep cash to allow for redemption, (2) a closed-end fund has a wider universe of securities to invest in, as it can invest in relatively illiquid securities (as, for example, in developing markets.),25,Active vs Passive Funds,Passive Try to track their chosen index, not outperform the index
39、. The only choice the passive fund manager has to make is to which index to track. Thus, how the fund performs relatively to its benchmark depends on how low it can keep its expenses. Active The fund manager try to outperform its benchmark index. Each fund can be classified by its “style”. The fund
40、attempts to track its benchmark, and yet beat it.,26,Stock Fund Styles,We can also classify actively managed mutual funds by their investment styles/objectives. There are several different ways in which we can do this: 1. Size based classification: Large-Cap, Mid-Cap, Small-Cap, etc. 2. Sector class
41、ification: Utilities, Technology, Health, etc. 3. Growth vs Value: the classification can be based on P/E, Market/Book Value, and dividend yield. 4. Domestic vs International.,27,Mutual Funds vs Hedge Funds,A U.S. “hedge fund“ is a U.S. private investment partnership invested primarily in publicly t
42、raded securities or financial derivatives. Because they are private investment partnerships, the SEC limits hedge funds to 99 investors, at least 65 of whom must be “accredited.“ (“Accredited“ investors often are defined as investors having a net worth of at least $1 million.) The reason to classify
43、 a fund as a investment partnership as a hedge fund - is to avoid SEC rules governing mutual funds.,28,Hedge Funds,There are some substantial differences between a hedge fund and a mutual fund:(1) A hedge fund can make a wider range of investments. It can, for example, invest in derivatives, go both
44、 long and short in the market, as well as take speculative positions in foreign exchange, commodities, etc. (2) A hedge fund is usually leveraged, while a mutual fund is not. (LTCM a famous hedge fund that went bust - had borrowed more than 50 times its capital). (3) The fee structure of a hedge fun
45、d is very different from that of a mutual fund. Often the fund managers take 20% of the profit, beyond a certain minimum return (subject to a “high water mark”). Examples include George Soross Quantum Fund, and Long Term Capital Management both of which are now closed.,29,An Example of A Mutual Fund
46、,The largest mutual fund is the Fidelity Magellan Fund, with assets of $76.885 billion (31/1/2002). The fund has been in existence since May 1963. It is currently closed to most new investment. What type of a fund is it? It invests in large caps, and blend of growth and value. Given its style, what
47、should its benchmark be? The appropriate benchmark, because of its emphasis on large caps, is the S&P 500. What kind of stocks would you buy if you were the manager of Magellan?,30,Magellans Stock Holding on 12/31/01,1.GENERAL ELECTRIC CO (4.76%) 2. CITIGROUP INC (3.95%) 3. MICROSOFT CORP 4. TYCO IN
48、TL LTD (2.69%) 5. AMER INTL GROUP INC (3%) 6. VIACOM INC CL B NON-VTG 7. EXXON MOBIL CORP (2.83%) 8. PFIZER INC 9. WAL MART STORES INC 10. HOME DEPOT INC,31,Magellan vs. the S&P 500,29.50% of Magellans holdings were in these top 10 stocks on 12/31/01. First, note that many of the stocks in the top h
49、oldings match the stocks with the highest weight in the S&P 500. Which stocks are missing from Fidelitys holdings Intel and IBM so it appears that Fidelity is underweighted in technology. Second, the weights are different. The S&P 500 had a weight of 22.09% in these 10 stocks. (Given these weights o
50、f Magellan, what do you estimate Magellans performance, year to date, compared to its benchmark?).,32,Magellan vs. S&P 500 vs. Average Fund in Group (as of 31 Dec 2001),Last 1 year: Magellan = -11.65%. S&P 500 = -11.89%. Average Growth Fund = -16.76%. Last 5 years. Magellan = 10.95%. S&P 500 = 10.70
51、%. Average Growth Fund = 8.56%. Last 10 years. Magellan = 12.90%. S&P 500 = 12.94%. Average Growth Fund = 11.19%. But Fidelity Magellan charges a “front-end load” a fee of 3% for entering the fund. The 1, 5, 10 year returns after the load are: -14.30%, 10.28%, 12.56%. So, after accounting for the load, Magellan underperforms the S&P 500 over each of these periods http:/
