(Part 1 of 2)
An index is a group of securities (e.g. stocks, bonds) that represents the collective movement and performance of that asset class, or the specific market territory or sector, or investment strategy. Stock or equity indexes are composed of stocks that meet certain criteria over a specified period; these indexes track the change in value of the included stocks. Investors use stock indexes to gain insight into the performance of the market as a whole, individual sectors, or specific stocks. In order to use equity indexes as a tool for managing your portfolio, or to simply understand index funds better, we outline the basics of stock indexes.
Types of stock indexes
1. Market-weighted indexes. Considered the most common and are calculated based on the total market capitalization of the constituent companies. The higher the market capitalization, the greater the weight a company has in the index.
2. Price-weighted indexes. Weightings are calculated based on the stock prices of the constituent companies. The higher the stock price, the greater the weight the company has in the index.
3. Equal-weighted indexes. All constituent companies are equally weighted regardless of market capitalization or stock price.
Uses of stock indexes
1. Benchmarking. To track the performance of a particular market or sector to serve as the benchmark to see how individual stocks measure up, whether these are equities that are included in a particular index or are comparable companies.
2. Risk Management. To hedge against market volatility by effectively diversifying an investment across the different stocks included in the index.
3. Exchange Traded Funds. To create financial products such as exchange-traded funds (ETFs) and mutual funds, which allow investors to gain exposure to a particular market or sector without having to buy individual stocks.
4. Investment Insight. To gain insight into the performance of individual companies and industries. If a particular sector or market is performing well, an investor may decide to invest in a particular company within that sector.
Stock rebalancing
This refers to the process of periodically (usually quarterly or annually) adjusting the components of a stock index to ensure that it remains representative of the underlying market or segment. The impact of index rebalancing on the markets can create opportunities for traders and investors:
1. Market Volatility. Inclusion to an index may lead to a temporary surge in demand as index funds and other investors purchase the stock to align with the new index weightings. On the other hand, the removal of a stock from an index may lead to a sell-off as index funds and other investors release some of their holdings, likewise to align with the new index weightings and asset composition. Increased trading activity can create short-term price volatility, particularly for smaller stocks that may experience large swings as a result of index rebalancing.
2. Trading Opportunities. Speculators may choose to purchase the stock ahead of the rebalancing, hoping to benefit from the subsequent price increase as a result of increased demand.
The impact of index rebalancing tends to have a smaller effect on overall market trends over the long-term. As the rebalancing of one index is usually offset by the rebalancing of others, leading to a net-zero effect on the market.
Inclusion in a stock index
Criteria for qualification to be included in a stock index may include market capitalization, trading volume, sector classification, and financial performance, although this varies depending on the index. Failing to meet such criteria merits removal from the index. Either way, inclusion and exclusion from a stock index can have a significant impact on the constituent companies in several ways:
1. Visibility and Prestige. Inclusion in a major stock index can increase a company’s visibility and investor interest, potentially leading to increased demand for its stock as index funds and other institutional investors are required to hold the stock.
2. Stock Liquidity. As demand increases, liquidity follows suit, making it easier for investors to buy and sell shares of the stock and overall improved trading activity.
3. Increase in Upside Opportunities. Increased demand can lead to a rise in valuation expectations, potentially leading to increased market capitalization, access to a wider investor pool, and improved ability to raise fresh capital to explore new growth opportunities.
The opposite can be expected when a stock is removed from the index. In a nutshell, being included in a major stock index is often seen as a sign of prestige and success, while being removed can be seen as a negative signal.
4. Impact on the broader stock market. Index rebalancing can impact the performance of the index as a whole. If a large-cap stock with a high weighting in an index is removed from the index, it could lead to a temporary decline in the value of the index. On the other hand, ensuring that the composition of an index accurately reflects the current market value of its constituent stocks can help to increase the efficiency of the market and reduce the potential for mispricings or inefficiencies.
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Watch out for Part 2 next week – we will be going over the different indexes tracking stocks in the Philippine market, from local to global indexes.
To learn more about equity indexes, join us on April 20, Thursday at the Dusit Thani Manila for the first installment of SharePHIL Capital Market Conversations: Effects of Index Rebalancing on Price and Market Behavior. Register at: https://bit.ly/sharephil202304
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About the authors:
Ed Francisco is President of BDO Capital and Investment Corporation, the investment banking arm of BDO Unibank Inc. and serves as the Vice Chairperson of the Shareholders’ Association of the Philippines (SharePHIL).
Karlo Lim is a Senior Associate of BDO Capital’s Corporate Finance Team with experience covering mergers and acquisitions, loan syndications, transaction advisory, and capital market transactions.
To learn more about SharePHIL, visit https://bit.ly/m/sharephil