Indices,

Diversification
&
Index Models

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Comm 324 --- W. Suo

Objective
Indices
Construction
Contribution to a portfolios risk
How to simplify the portfolio inputs
Index models
Decomposition of risk
Systematic and unsystematic
Diversification
Other multifactors
Fama-French 3 factor model, etc

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Comm 324 --- W. Suo

Stock Indices
Uses

Track average returns

Comparing performance of managers
Base of derivatives

Factors in constructing or using an Index

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Representative?
Broad or narrow?
How is it constructed?

Comm 324 --- W. Suo

Examples of Equity Indices

o
o
o
o

o
o
o
o
o

o
o
o
o
o
o

Canadian
S&P/TSX 300 Composite Index
TSX 35 (also known as Toronto 35 or T35)
TSX 100
S&P/TSX 60

US
Dow Jones Industrial Average (30 Stocks)
Standard & Poors 500 Composite
NASDAQ Composite
NYSE Composite
Wilshire 5000

International
TSE (Tokyo) - Nikkei 225 & Nikkei 300
FTSE (Financial Times of London)
Dax
Han Seng
Shanghai Composite Index
Region and Country Indexes

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EAFE
Far East
United Kingdom
W. Suo

Bond Indices

Scotia Capital (Canada)

Lehman Brothers
Merrill Lynch
Salomon Brothers

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Comm 324 --- W. Suo

Construction of Indices
How are stocks weighted?

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Market-value weighted (S&P500, NASDAQ, S&P/TSX

Composite)
Price weighted (DJIA)
Equally weighted (Value Line Index)

Comm 324 --- W. Suo

Contrasting Two Well-Known

Stock Market Indicators

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Dow-Jones Industrial Average (DJIA)

Begun in 1884 with 11 stocks
Average has contained 30 stocks since 1928
o

Misleading name
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Only large firms are in the average

New firms are not included
Some firms may be more utility than industrial firms

DJIA Divisor
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Only large, successful firms are in the average

In 1928 the prices of the 30 stocks were summed and divided by 30

However, stock splits and stocks dividends impact the divisor

W. Suo

Stock Splits and DJIA Divisor

As an example, consider the hypothetical stocks

Stock

Price

$50

$10

Total
Average

$60

60/2 = 30

The stock split changed the price per share, but

the stockholders wealth has remained the same
each stockholder in X has twice as many

shares as before.
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If Stock X
undergoes a
2 for 1 stock
split

Stock

Price

$25

$10

Total
Average

$35
35/2 = 17.5

If the divisor remains at 2, the average

will drop, even though the aggregate
market value of X remains the same.
The divisor value must drop to reflect
the stock split.
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Dow-Jones Industrial Average

Points
DJIA is price-weighted
More weight is given to higher priced stocks

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Each point represents a few pennies of stock price

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S&P 500 Stocks Composite Index

First developed in 1923

Has been at the 500 stock level since 1957

Uses a market weighting scheme

Contained 233 stocks

Each securitys weight is based on the total market value of the

firm
Corresponds to the investment opportunities that exist in U.S.

How is it calculated?

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W. Suo

S&P 500 Stocks Composite

Index

used to calculate S&P500

Equation

Automatically adjusts for stock splits, etc.

Base period with a base index value of 10
Index components change slightly each year
500 stocks in index are about 17% of the stocks listed on NYSE
But aggregate market value is > 50% of aggregate market value of
all stocks listed on NYSE & AMEX

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Comm 324 --- W. Suo

Diversification
Famous quotes

I prefer to keep all my eggs in one basket and watch that basket
closely.
Diversification is a protection against ignorance. It makes very little
sense for those who know what theyre doing.
If you are a know-something investor, able to understand business
economics and to find five to ten sensibly priced companies that
possess important long-term competitive advantages, conventional
portfolio diversification (broadly based active portfolios) makes no
sense for you.

What is your take?

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Comm 324 --- W. Suo

Contribution to a portfolios
risk
For a large and diversified portfolio, it is the
covariance of the stock that contributes to the
overall risk of the portfolio?

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Why?

Comm 324 --- W. Suo

Diversification
Random selection

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Diversification
The effect of random diversification

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Markowitz diversification
Can we do better than the
random selection?

Markowitz diversification
How to simplify the
approach?
What kind of risk is reduced?

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Single Index Model

(ri rf ) i i (rM rf ) ei
= stocks expected return if markets excess return is zero
= the component of return due to market movements
= the component of return due to unexpected firm-specific
events
and are assumed to be uncorrelated

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Risk Premium Format

Let:

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Risk premium
format

Comm 324 --- W. Suo

(e)

2ii2M
22i

Measuring Components of Risk

=total
variance
=systematic variance
=unsystematic variance

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Components of Risk
Market or systematic risk

risk related to the macro economic factor or market

index

Unsystematic or firm specific risk:

risk not related to the macro factor or market index

Total risk = Systematic + Unsystematic

Risk is represented by variance (not standard

deviation)

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(
e
)
(R1e)

2
2
2
2
M
2
2i

Examining Percentage of
Variance

Total Risk = Systematic +Unsystematic

i M
R squared
2

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Security Characteristic Line

ExcessReturns(i)

. . .. .
.

. . . .. .
.
.
. . . .
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22

. .
.

. . .

.
.

.
.

. . . .

. .
.

SCL

. .
.

Excessreturns
. . .onmarketindex
.
.

Comm 324 --- W. Suo

e
i
iP
i
M
i

e
P
P
P
M
P
2
2
2
2

(
)
M
n
n
n
1n
1Pn
;i1i

;i1ieP1n

e1i
Index Model and Diversification

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RiskReductionwith
Diversification
St.Deviation
UniqueRisk

2(eP)=2(e)/n
P2M2
MarketRisk
Numberof
Securities
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Industry Prediction of Beta

Capital Markets and Merrill Lynch examples

BMO

BMO NB uses returns not risk premiums

r a brM e *

a has a different interpretation: + rf (1-)

Merill Lynchs adjusted : (sample beta)+

Forecasting beta as a function of past beta

Forecasting beta as a function of firm size, growth, leverage
etc.

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Multifactor Models

Use
factors in addition to market return

Examples include industrial production, expected inflation etc.

Estimate a beta for each factor using multiple regression

Fama and French

Returns a function of size and book-to-market value as well as market

returns

Where
SMB=small minus big: return of portfolio of small stocks in excess
of return on a portfolio of large stocks
HML=high minus low: return of portfolio of high book-to- market ratio
stocks in excess of return on a portfolio of high book-tomarket ratio stocks
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