IX. INDEXES AND INDEX FUND INVESTING

1
IX. INDEXES AND INDEX FUND INVESTING
2
A. WHY FOLLOW INDICIES

• Benchmark of Performance A standardized measure
  of the returns provided by a financial instrument
  against with the returns of a group of similar
  securities
• Indices provide an indication of returns for
  various market segments

3
B. TYPES OF STOCK INDICES

• Capitalization Weighted Based upon the market
  capitalization (stock price x number of shares
  outstanding) of the stocks in the index
• Price Weighted Indices Stocks in the index are
  valued based upon their market price only
• Equal Weighted Indices Measure the percentage
  change in market value for each stock in the index

4
B. TYPES OF STOCK INDICES

• Arithmetic Mean Indices Averages the return on
  all stocks in the index
• Geometric Mean Indices Based upon the compound
  returns of stocks in the index

5
C. SPECIFIC TYPES OF STOCK INDICES

• SP 500 Contains 500 of the largest by market
  capitalization widely traded stocks
• Dow Jones Industrial Average Consists of 30
  large capitalization stocks (started in 1896)
• Russell 2000 Contains a mix of small and large
  capitalization stocks

6
C. SPECIFIC TYPES OF STOCK INDICES

• Wilshire 5,000 A basket of 5,000 stocks,
  meant to replicate the rate of return of the
  market as a whole
• SP Midcap 400 Contains 400 widely traded
  midcap stocks (between 1,000,000,000 and
  5,000,000,000 in market capitalization)

7
D. INDEXES AS BENCHMARKS

• Indexes show the relative performance of a
  portfolio compared to the relevant market
• In order to be an accurate benchmark, one must
  compare the asset class or subclass in an index
  to the mix of securities in a portfolio
• Indices can be used to compare against a
  porfolios risk/return profile (the risk of
  stocks in a portfolio compared with overall
  returns) and portfolio volatility (range of rates
  of returns)

8
E. INDEX INVESTING

• Why
• Efficient Market Theory It is impossible for
  investors to consistently outperform an index
  exceptions include Warren Buffet, George Soros,
  etc.
• Diversifies a portfolio without having to own a
  large number of stocks
• Avoids the risk of bad bets
• Low management fees Index funds are cheap to
  operate, and there is much competition between
  funds

9
E. INDEX INVESTING

• Index Mutual Funds Sold by fund companies
  and/or brokers, locks up funds in a managed
  account, with holdings priced at the end of each
  business day
• Exchange Traded Funds (ETFs) Traded on stock
  exchanges, bought through a brokerage firm,
  invests in the relevant index, with supply and
  demand managed by brokerage firms

10
E. INDEX INVESTING

• Types of Index Funds
• Full Replication Holds exactly the securities
  contained in an index
• Enhanced Index Funds Managers overweight or
  underweight index stocks to capitalize on
  perceived value
• Quant Funds Are based upon a mathematical
  model, Quant Funds pick individual stocks from
  the index that are expected to outperform the
  market