I got a suggestion from a Facebook user that I could probably share about construction of indices and also how our blue chips are actually weighted in the Straits Times Index (STI).
Before you proceed, do note that what I am about to share is quite dry and technical but i ll try my best to make it as simple as possible. For those who don't catch it, no worries at all. Knowing all these actually doesn't give you an edge in investing anyway. It's just good to know. :)
So here it is!
There are three ways an index can be constructed:
1. Priceweighted Average
2.Valueaveraged
3.Equalweighted
1. Priceweighted Average
A priceweighted average assumes that stocks are weighted based on their price per share. It is termed 'priceweighted' because the similar percentage increase in higher price stocks will have greater influence over the average than that of a lower price stock. In Singapore's context, it's like taking one share of each of the thirty blue chips, add up their individual prices and divide by 30.
It's
considered "price weighted" because the same percent increase in a
higher priced stock influences the average more than that of a lower
priced stock.  See more at:
http://wiki.fool.com/How_to_Calculate_Price_Weighted_Average_for_Stocks#Adjusting_the_Divisor_for_Stock_Splits
It's
considered "price weighted" because the same percent increase in a
higher priced stock influences the average more than that of a lower
priced stock.  See more at:
http://wiki.fool.com/How_to_Calculate_Price_Weighted_Average_for_Stocks#Adjusting_the_Divisor_for_Stock_Splits
It's
considered "price weighted" because the same percent increase in a
higher priced stock influences the average more than that of a lower
priced stock.  See more at:
http://wiki.fool.com/How_to_Calculate_Price_Weighted_Average_for_Stocks#Adjusting_the_Divisor_for_Stock_Splits
It's
considered "price weighted" because the same percent increase in a
higher priced stock influences the average more than that of a lower
priced stock.  See more at:
http://wiki.fool.com/How_to_Calculate_Price_Weighted_Average_for_Stocks#Adjusting_the_Divisor_for_Stock_Splits
One of such indices is Dow Jones Industrial Average (30 Stocks)
It's
considered "price weighted" because the same percent increase in a
higher priced stock influences the average more than that of a lower
priced stock.  See more at:
http://wiki.fool.com/How_to_Calculate_Price_Weighted_Average_for_Stocks#Adjusting_the_Divisor_for_Stock_Splits
It's
considered "price weighted" because the same percent increase in a
higher priced stock influences the average more than that of a lower
priced stock.  See more at:
http://wiki.fool.com/How_to_Calculate_Price_Weighted_Average_for_Stocks#Adjusting_the_Divisor_for_Stock_Splits
Here's the illustration:
It's
considered "price weighted" because the same percent increase in a
higher priced stock influences the average more than that of a lower
priced stock.  See more at:
http://wiki.fool.com/How_to_Calculate_Price_Weighted_Average_for_Stocks#Adjusting_the_Divisor_for_Stock_Splits
Stock

Price_{0} ($)

Quantity_{0}

Price_{1} ($)

Quantity_{1}

A

10

40

15

40

B

60

80

30

160

C

140

50

150

50

Day 0
Price of Index_{0} = (10+60+140)/3= $70
So at the end of the day 0, assuming 2 for 1 stock split for stock B
So we'll recalculate denominator : (10+30+140)/x= $70 . Solve for x= 2.571
Day 1
Now index_{1} = (15+30+150)/2.571= $75.8
Note that the change in index price is due to the price movements from stock A and C, which went up from $10 to $15, and $140 to $150 respectively.
Note: if there's only stock split and no price movements in A&C, the price of index_{1 }should be the same as index_{0}=$70.
In simple words: stocks which price/share are numerically high e.g 3M ($161.14) as compared to Cisco ($29.24) will have a greater influence over the index.
2.Valueaveraged
Valueaveraged index are better known as Capitalization Weighted Index or Market Value weighted Index.
For value average, the index construction considers the price AND the number of shares outstanding.
Hence amount invested in each stock is proportional to market value of each stock.
To simplify things, let's use back the same example to calculate value averaged.
Stock

Price_{0} ($)

Quantity_{0}

Price_{1} ($)

Quantity_{1}

A

10

40

15

40

B

60

80

30

160

C

140

50

150

50

Let's call this Index_{v}
Index_{v }= [15*40+30*60+150*50]/[10*40+60*80+140*50] *100
= 105.74
Example of such indices are Standard & Poor’s 500 Composite, NASDAQ Composite (> 3000 firms), NYSE Composite and Wilshire 5000 (> 6000 stocks) AND our favourite Straits Times Index (30 Stocks)
In simple words: stocks with high market capitalization with have a greater influence over the index.
Singtel is priced at $4.32, numerically lower than Jardine C&C (41.23) but has a higher market cap ($68.8b vs $14.6b) so former has a greater influence than the latter in such index.
3.Equalweighted
This takes into account price and the number of shares, but invests the same amount of $ in each stock regardless of market value of the stock. It's like allocating $3000 to buy each of the 30 blue chips, $3,000/30= $100 in each stock, regardless of how much the stock costs.
Let's call this Index_{E} and let's say we invest $300 in each stocks equivalently...
_{}
Stock

Price_{0} ($)

Quantity_{0}

Price_{1} ($)

Quantity_{1}

A

10

40

15

40

B

60

80

30

160

C

140

50

150

50

Index_{E }= [15*30+30*10+150*2.142857143]/[10*30+60*5+140*2.142857143] *100
= 119.05
This is abit tricky but let me explain.
Focus on the denominator, as we are using $300 to buy the share regardless of the share price.
$10*30=$300,
$60*5=$300,
$140*2.142857143=$300.
So no matter how the number turns out, I apply it to the numerator as well, but do note that there was a stock split so ideally with the stock split of 2 to 1, share price should drop by 2 times, but we know that this drop shouldn't affect the index, so we multiply twice the amount.
I only mananged to find an ETF which is equalweighted Rydex S&P 500 Equal Weight ETF (ARCA:RSP) . It tracks the EWI; the ETF of choice for the S&P 500, is the State Street SPDR S&P 500 (ARCA:SPY).
In other words, it is the equal weight version of the popular S&P 500 Index.
Interesting huh?
It's fine if you don't understand every part but at least you know:
1. There are three ways an index can be constructed and;
2. STI is valueaveraged index, which means that stocks with relatively higher market capitalization such as DBS($52.8b) and Singtel ($68.8b) and the famous Jardine conglomerates Jardine C&C(14.6b), Jardine Mattheson ($42.8b), Jardine Strategic Holdings ($38.9b) will have a higher weightage in STI.
(market cap source: Bloomberg)
If you spot any calculation mistakes or any errors, please feel free to drop me an email: kelvin17@gmail.com. Or if there's any queries, you can drop a comment below too.
Haha, I am from Engineering background but I believe finance students should be quite familiar with all these...
Anyway thanks for reading. I am no guru and I have no plans to conduct investment/trading courses or whatsoever as I already have my own career and I am completing my studies soon. I am doing this as a hobby, to interact and learn from likeminded people who shares the same passion as me and to inspire young people to invest early.
If you like what I've written, do support me by simply liking my page by clicking here or at the top right hand corner (in desktop view)
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Thanks and have a blessed weekend! :) Will write more soon!
End
You could try comparing the STI stocks between Price Weighted, and Equal Weighted to see how they do vs the capitalization weight, chances are you will find price weighted does better
ReplyDeleteHi Vatsa,
ReplyDeleteThanks for your suggestion!
I have not tried comparing before but I did went to search online and realize there are varied conclusions on which index does better. I believe time frame and stocks which made up the index also plays a role too. If you have compared before probably you can share with us? :)
Hi, to add on to your post, you could try to show some of the benefits of indexing vs unit trusts and individual stock picking. I did a blog post on it and would appreciate if you could leave some comments
ReplyDeletehttp://someideasoninvestinginsingapore.blogspot.com/2015/06/whatarebenefitsofindexing.html
Thanks!
Hihi,
DeleteThanks for dropping by my blog.
Sure, will drop you some comments shortly.
Have a blessed weekend! :)
Cheers,
EoTS