The Main Goals:
Traders’ Academy Students Can:
Understand how index values are calculated
Learn how those values are used to calculate performance
Discover why index values vary widely across indexes and index providers
Learn the difference between price return and total return index values
How are index values calculated?
Here is a hypothetical market cap-weighted index that includes five constituents.
The market value for each stock is calculated by multiplying its price by the number of shares included in the index, and each stock’s weight in the index is determined based on its market value relevant to the total market value of the index.
Stock A, for example, has a share price of $3, and there are 30 shares of this stock in the index, so its market value is $90 ($3 X 30 shares = $90).
The total market value of every stock in the index is $660, so Stock A’s weight, or representation within the index is 13.6% ($90 / $660 = 13.6%).
When an index is first created, a starting (base) value is chosen. In our example, we will use 100 as the base value. Now that we have the total market value of our index and our base value, the 2. next step is to determine the index divisor by dividing the total market value of the index by the base index value of 100 ($660 / 100 = 6.6).
Each day, as the market values of the stocks in the index fluctuate based on changes to their prices, the new total market value of the index is divided by the same divisor (6.6) to produce a new index value as you can see in this example.
The divisor remains constant until the index constituency changes. For example, if a stock is delisted or a stock split occurs, the divisor will be recalculated to be reflective of the new index membership.
How are index values used to calculate performance?
Index performance between any two dates can be calculated by dividing the ending index value by the beginning index value as follows. Using our hypothetical index as an example:
Day 1 index value = 100.0
Day 4 index value = 104.5
((104.5 / 100) -1) x 100 = 4.5%
Why do index values vary so widely across indexes and index providers?
Comparing the values of indexes designed to measure the same market or market segment can be daunting, and in most cases irrelevant. Indexes can be started, or “launched” at different points in time and with different base values, so it is important not to get hung up on the values themselves, but rather the growth (or decline) of those values over time.
For example, if Index A had a base value of 100 in January of 2015 and that value increased to 150 as of January 2018, the index value increased by 50% over that 3-year period.
Index B measures the exact same market, but its starting base value was 1,000 in January of 2015, and its value grew to 1,500 as of January 2018. The value of this index also rose 50% over the same 3-year period.
Comparing their January 2018 values of 150 and 1,500 is irrelevant, as they were started with different base numbers. It’s their performance, not their values, that should be compared.
What is the difference between a price return and total return index values?
A price return value measures the changes in the stock prices and market values of the index constituents over time, as shown in the example above.
A total return value measures the changes in stock prices and market values as well, but also captures the dividends paid to shareholders by the companies in the index by reinvesting the dividends. The dividend reinvestment and compounding are done at the total index level, not at the security level.
Disclosure: Interactive Brokers
Information posted on IBKR Traders’ Academy that is provided by third-parties and not by Interactive Brokers does NOT constitute a recommendation by Interactive Brokers that you should contract for the services of that third party. Third-party participants who contribute to IBKR Traders’ Academy are independent of Interactive Brokers and Interactive Brokers does not make any representations or warranties concerning the services offered, their past or future performance, or the accuracy of the information provided by the third party. Past performance is no guarantee of future results.
This material is from FTSE Russell and is being posted with permission from FTSE Russell. The views expressed in this material are solely those of the author and/or FTSE Russell and IBKR is not endorsing or recommending any investment or trading discussed in the material. This material is not and should not be construed as an offer to sell or the solicitation of an offer to buy any security. To the extent that this material discusses general market activity, industry or sector trends or other broad based economic or political conditions, it should not be construed as research or investment advice. To the extent that it includes references to specific securities, commodities, currencies, or other instruments, those references do not constitute a recommendation to buy, sell or hold such security. This material does not and is not intended to take into account the particular financial conditions, investment objectives or requirements of individual customers. Before acting on this material, you should consider whether it is suitable for your particular circumstances and, as necessary, seek professional advice.
Disclosure: Stock Symbols
Any stock, options or futures symbols displayed are for illustrative purposes only and are not intended to portray recommendations.