2. Index Construction and Management
c. describe the choices and issues in index construction and management;
d. compare the different weighting methods used in index construction;
e. calculate and analyze the value and return of an index given its weighting method;
f. describe rebalancing and reconstitution of an index;
What are the five steps to construct a security market index?
1. Identify the target market. Which market should the index represent?
2. Select specific securities to include in the index. How many securities to include? Which ones?
3. Determine the weight to be allocated to each security in the index
4. Decide how often the index should be rebalanced
5. Decide when the security selection and weighting decisions should be re-examined
What are the four weighting methods used when determining the weight to be allocated to each security in a security market index?
1. Price Weighting - an arithmetic average of current prices
2. Equal Weighting - all stocks carry equal weight regardless of their price or market value
3. Market-Capitalization Weighting - measurement is generated by deriving the initial total market value of all stocks used in the series
4. Fundamental Weighting - stocks are weighted by one or many economic fundamental factors, especially accounting figures, which are commonly used when performing corporate valuation
What is index rebalancing?
Rebalancing is adjusting the weights of the constituent securities in an index. This is done to maintain the weight of each security consistent with the index's weighting method. There is no need to rebalance price-weighted indices.
What is index reconstitution?
Reconstitution is changing the composition of an index. Reconstitution is undertaken to ensure the index represents the desired target market.