Beyond separate stock indexes and bond indexes for individual countries, a natural step is the development of a composite series that measures the performance of all securities in a given country. A composite series of stocks and bonds makes it possible to examine the benefits of diversifying with a combination of asset classes such as stocks and bonds in addition to diversi- fying within the asset classes of stocks or bonds. There are two such series available.
First a market-value-weighted index called Merrill Lynch–Wilshire Capital Markets Index (ML–WCMI) measures the total return performance of the combined U.S. taxable fixed-income and equity markets. It is basically a combination of the Merrill Lynch fixed-income indexes and the Wilshire 5000 common-stock index. As such, it tracks more than 10,000 stocks and bonds.
The makeup of the index is as follows (as of July 2001):
The second composite series is the Brinson Partners Global Security Market Index (GSMI) series that contains both U.S. stocks and bonds but also includes non-U.S. equities and nondol- lar bonds. The specific breakdown is as follows (as of July 2001):
Brinson Partners Global Security Market Index (GSMI) Merrill Lynch–Wilshire
U.S. Capital Markets Index
(ML–WCMI) Global Government Bond
Market Indexes
SECURITY PERCENT OFTOTAL
Treasury bonds 10.05%
Agency bonds 4.40
Mortgage bonds 10.25
Corporate bonds 8.05
OTC stocks 7.74
AMEX stocks 2.10
NYSE stocks 57.41
100.00%
MEANANNUALSECURITYRISK-RETURNS AND CORRELATIONS 167
SECURITIES PERCENT
Equities
U.S. large capitalization 28
U.S. small and mid-cap 12
Non-U.S. developed country 22
Emerging markets 3
Fixed Income
U.S. domestic investment grade 21
U.S. high yield 3
Nondollar developed country 9
Emerging markets 2
Total 100
13This GSMI series is used in a study that examines the effect of alternative benchmarks on the estimate of the security market and estimates of individual stock betas. See Frank K. Reilly and Rashid A. Akhtar, “The Benchmark Error Prob- lem with Global Capital Markets,” Journal of Portfolio Management 22, no. 1 (Fall 1995). Brinson Partners has a Mul- tiple Markets Index (MMI) that also contains venture capital and real estate. Because these assets are not actively traded, the value and rate of return estimates tend to be relatively stable, which reduces the standard deviation of the series.
Although related to the relative market values of these asset classes, the weights specified are not constantly adjusted. The construction of the GSMI used optimization techniques to identify the portfolio mix of available global asset classes that match the risk level of a typical U.S. pen- sion plan. The index is balanced to the policy weights monthly.
Because the GSMI contains both U.S. and international stocks and bonds, it is clearly the most diversified benchmark available with a weighting scheme that approaches market values.
As such, it is closest to the theoretically specified “market portfolio of risky assets” referred to in the CAPM literature.13
MEAN ANNUAL SECURITY RISK-RETURNS AND CORRELATIONS
The use of security indexes to measure returns and risk was demonstrated in Chapter 3 where we showed the average annual price change or rate of return and risk measure for a large set of asset indexes. As one would expect, there were clear differences among the series due to the different asset classes (e.g., stocks versus bonds) and when there were different samples within asset classes (e.g., the results for NYSE stocks versus Nasdaq stocks versus non-U.S. stocks). Equally important, the results were generally consistent with what one should expect in a risk-averse world—that is, there was a positive relationship between the average rate of return for an asset and its measure of risk—for example, the return-risk results for T-bills versus the results for the S&P 500 stocks. The point is, these security market indexes can be used to measure the histori- cal performance of an asset class but can also be used as benchmarks to evaluate the performance of a money manager for a mutual fund, a personal trust, or a pension plan.
We also considered the correlation of monthly returns among the asset classes, which indi- cated a wide range of correlations. Because diversification requires combining assets with low positive or ideally negative correlation, these results indicated which assets are optimal for investors depending upon the current portfolio. Finally, the correlation of asset returns with the rate of inflation implied good and poor inflation hedge assets.
The Internet Investments Online
We’ve seen several previous Web sites that offer online users a look at current market conditions in the form of a time-delayed market index (some sites offer real-time stock and index prices, but only at a cost to their customers). Here are a few others:
http://www.bloomberg.com The site is somewhat of an Internet version of the
“Bloomberg machine,” which is prevalent in many brokerage house offices. It offers both news and current data on a wide variety of global market securities and indexes, including historical charts.
The site contains information on interest rates, commodities, and currencies.
http://www.barra.com Barra offers down- loadable historical data on several S&P/Barra equity indexes, including S&P 500, midcap, and small cap indexes as well as Canadian equity indexes. Also included is information about the characteristics of the indexes.
http://www.msci.com Morgan Stanley Capi- tal International contains links to sites which offer downloadable data on several of its international equity indexes. Information and graphics on sev- eral fixed income indexes are available, too.
http://www.barcap.com/euroidx/data/
Summary.shtmland the home page of Barclays Capital, http://www.barcap.com, offer infor- mation on European bond market indexes.
Additional global bond index performance information can be found at
http://www.datastream.com/product/
investor/index.htm. Information on Japanese bond indexes are available at a Daiwa Institute of Research site, http://www.dir.co.jp/
InfoManage/datarsc.html.
http://www.world-exchanges.org The Web site of the World Federation of Exchanges contains many links and much data related to global securities markets.
• Given the several uses of security market indicator series, you should know how they are constructed and the differences among them. If you want to use one of the many series to learn how the “market” is doing, you should be aware of what market you are dealing with so you can select the appropriate index. As an example, are you only interested in the NYSE or do you also want to consider the AMEX and the OTC? Beyond the U.S. market, are you interested in Japanese or U.K. stocks, or do you want to examine the total world market?14
• Indexes are also used as benchmarks to evaluate portfolio performance.15In this case, you must be sure the index (benchmark) is consistent with your investing universe. If you are investing worldwide, you should not judge your performance relative to the DJIA, which is limited to 30 U.S. blue-chip stocks.
For a bond portfolio, the index should match your investment philosophy. Finally, if your portfolio con- tains both stocks and bonds, you must evaluate your performance against an appropriate combination of indexes or one of the indexes that specifically combines the indexes for you.
• Whenever you invest, you examine numerous market indexes to tell you what has happened and how successful you have been. The selection of the appropriate indexes for information or evaluation will depend on how knowledgeable you are regarding the various series. The purpose of this chapter is to help you understand what to look for and how to make the right decision.
Summary
14For a readable discussion on this topic, see Anne Merjos, “How’s the Market Doing?” Barron’s, 20 August 1990, 18–20, 27, 28.
15Chapter 26 includes an extensive discussion of the purpose and construction of benchmarks and considers the evalua- tion of portfolio performance.
1. Discuss briefly several uses of security market indicator series.
2. What major factors must be considered when constructing a market index? Put another way, what characteristics differentiate indexes?
Questions
3. Explain how a market indicator series is price weighted. In such a case, would you expect a $100 stock to be more important than a $25 stock? Why or why not?
4. Explain how to compute a market-value-weighted series.
5. Explain how a price-weighted series and a market-value-weighted series adjust for stock splits.
6. Describe an unweighted price indicator series and describe how you would construct such a series.
Assume a 20 percent price change in GM ($40/share; 50 million shares outstanding) and Coors Brewing ($25/share and 15 million shares outstanding). Explain which stock’s change will have the greater impact on such an index.
7. If you correlated percentage changes in the Wilshire 5000 equity index with percentage changes in the NYSE composite and the Nasdaq composite index, would you expect a difference in the correla- tions? Why or why not?
8. There are high correlations among the monthly percentage price changes for the alternative NYSE indexes. Discuss the reason for this similarity: Is it size of sample, source of sample, or method of computation?
9. You learn that the Wilshire 5000 market-value-weighted series increased by 16 percent during a specified period, whereas a Wilshire 5000 equal-weighted series increased by 23 percent during the same period. Discuss what this difference in results implies.
10. Why is it contended that bond market indexes are more difficult to construct and maintain than stock market indexes?
11. The Wilshire 5000 market-value-weighted index increased by 5 percent, whereas the Merrill Lynch–Wilshire Capital Markets Index increased by 15 percent during the same period. What does this difference in results imply?
12. The Russell 1000 increased by 8 percent during the past year, whereas the Russell 2000 increased by 15 percent. Discuss the implication of these results.
13. Based on what you know about the Financial Times (FT) World Index, the Morgan Stanley Capital International World Index, and the Dow Jones World Stock Index, what level of correlation would you expect among monthly rates of return? Discuss the reasons for your answer based on the factors that affect indexes.
PROBLEMS 169
1. You are given the following information regarding prices for stocks of the following firms:
a. Construct a price-weighted index for these three stocks, and compute the percentage change in the series for the period from T to T+1.
b. Construct a market-value-weighted index for these three stocks, and compute the percentage change in the series for the period from T to T+1.
c. Briefly discuss the difference in the results for the two stock indexes.
2. a. Given the data in Problem 1, construct an equal-weighted index by assuming $1,000 is invested in each stock. What is the percentage change in wealth for this equal-weighted portfolio?
b. Compute the percentage of price change for each of the stocks in Problem 1. Compute the arith- metic average of these percentage changes. Discuss how this answer compares to the answer in 2a.
c. Compute the geometric average of the three percentage changes in 2b. Discuss how this result compares to the answer in 2b.
3. For the past five trading days, on the basis of figures in The Wall Street Journal, compute the daily percentage price changes for the following stock indexes:
a. DJIA b. S&P 500
PRICE
Stock Number of Shares T T+1
Lauren Corp. 1,000,000 60 80
Kayleigh Co. 10,000,000 20 35
Madison Ltd. 30,000,000 18 25
Problems
c. Nasdaq Composite Index d. FT-100 Share Index e. Nikkei Stock Price Average
Discuss the difference in results for a and b, a and c, a and d, a and e, d and e. What do these differences imply regarding diversifying within the United States versus diversifying between countries?
4.
PRICE SHARES
Company A B C A B C
Day 1 12 23 52 500 350 250
Day 2 10 22 55 500 350 250
Day 3 14 46 52 500 175a 250
Day 4 13 47 25 500 175 500b
Day 5 12 45 26 500 175 500
aSplit at close of Day 2
bSplit at close of Day 3
a. Calculate a Dow Jones Industrial Average for Days 1 through 5.
b. What effects have the splits had in determining the next day’s index? (Hint: Think of the relative weighting of each stock.)
c. From a copy of The Wall Street Journal, find the divisor that is currently being used in calculating the DJIA. (Normally this value can be found on pages C2 and C3.)
5. Utilizing the price and volume data in Problem 4.
a. Calculate a Standard & Poor’s Index for Days 1 through 5 using a beginning index value of 10.
b. Identify what effects the splits had in determining the next day’s index. (Hint: Think of the rela- tive weighting of each stock.)
6. Based on the following stock price and shares outstanding information, compute the beginning and ending values for a price-weighted index and a market-value-weighted index.
DECEMBER31, 2002 DECEMBER31, 2003
Price Shares Outstanding Price Shares Outstanding
Stock K 20 100,000,000 32 100,000,000
Stock L 80 2,000,000 45 4,000,000a
Stock M 40 25,000,000 42 25,000,000
aStock split two-for-one during the year
a. Compute the percentage change in the value of each index.
b. Explain the difference in results between the two indexes.
c. Compute the results for an unweighted index and discuss why these results differ from the others.
Fisher, Lawrence, and James H. Lorie. A Half Century of Returns on Stocks and Bonds. Chicago: Univer- sity of Chicago Graduate School of Business, 1997.
Ibbotson Associates. Stocks, Bonds, Bills and Inflation. Chicago: Ibbotson Associates, annual.
Reilly, Frank K., and David J. Wright, “Bond Market Indexes.” In The Handbook of Fixed-Income Secu- rities, 6th ed., ed. Frank J. Fabozzi. New York: McGraw-Hill, 2001.
References
APPENDIX 171
Foreign Stock Market Indexes
APPENDIX Chapter 5
Index Name Number of Stocks Weights of Stocks Calculation Method History of Index ATX-index (Vienna) All stocks listed on the
exchange
Market capitalization Value weighted Base year 1967, 1991 began including all stocks (Value = 100)
Swiss Market Index 18 stocks Market capitalization Value weighted Base year 1988, stocks
selected from the Basle, Geneva, and Zurich Exchanges (Value = 1,500) Stockholm General Index All stocks (voting) listed
on exchange
Market capitalization Value weighted Base year 1979, continuously updated (Value = 100) Copenhagen Stock
Exchange Share Price Index
All stocks traded Market capitalization Value weighted Share price is based on average price of the day
Oslo SE Composite Index (Sweden)
25 companies Base year 1972
(Value = 100) Johannesburg Stock
Exchange Actuaries Index
146 companies Market capitalization Value weighted Base year 1959
(Value = 100) Mexican Market Index Variable number, based
on capitalization and liquidity
Value weighted (adjustment for value of paid-out dividends)
Base year 1978, high dollar returns in recent years
Milan Stock Exchange MIB
Variable number, based on capitalization and liquidity
Weighted arithmetic average
Change base at beginning of each year (Value = 1,000) Belgium BEL-20 Stock
Index
20 companies Market capitalization Value weighted Base year 1991
(Value = 1,000) Madrid General Stock
Index
92 stocks Market capitalization Value weighted Change base at beginning
of each year Hang Seng Index
(Hong Kong)
33 companies Market capitalization Value weighted Started in 1969, accounts for 75 percent of total market
FT-Actuaries World Indexes
2,212 stocks Market capitalization Value weighted Base year 1986
FT-SE 100 Index (London)
100 companies Market capitalization Value weighted Base year 1983
(Value = 1,000) CAC General Share Index
(French)
212 companies Market capitalization Value weighted Base year 1981
(Value = 100) Morgan Stanley World
Index
1,482 stocks Market capitalization Value weighted Base year 1970
(Value = 100) Singapore Straits Times
Industrial Index
30 stocks Unweighted
German Stock Market Index (DAX)
30 companies (Blue Chips)
Market capitalization Value weighted Base year 1987 (Value = 1,000) Frankfurter Allgemeine
Zeitung Index (FAZ) (German)
100 companies (Blue Chips)
Market capitalization Value weighted Base year 1958 (Value = 100) Australian Stock
Exchange Share Price Indices
250 stocks (92 percent of all shares listed)
Market capitalization Value weighted Introduced in 1979
Dublin ISEQ Index 71 stocks (54 official, 17 unlisted); all stocks traded
Market capitalization Value weighted Base year 1988 (Value = 1,000)
Index Name Number of Stocks Weights of Stocks Calculation Method History of Index Dublin ISEQ Index 71 stocks (54 official,
17 unlisted); all stocks traded
Market capitalization Value weighted Base year 1988 (Value = 1,000) HEX Index (Helsinki) Varies with different share
price indexes
Market capitalization Value weighted Base changes every day Jakarta Stock Exchange All listed shares
(148 currently)
Market capitalization Value weighted Base year 1982 (Value = 100) Taiwan Stock Exchange
Index
All ordinary stocks (listed for at least a month)
Market capitalization Value weighted Base year 1966 (Value = 100) TSE 300 Composite
Index (Toronto)
300 stocks (comprised of 14 subindexes)
Market capitalization (adjusted for major shareholders)
Value weighted Base year 1975 (Value = 1,000) KOSPI (Korean
Composite Stock Price Index)
All common stocks listed on exchange
Market capitalization (adjusted for major shareholders)
Value weighted Base year 1980 (Value = 100)
Foreign Stock Market Indexes (continued)
APPENDIX Chapter 5
Chapter 6 Efficient Capital Markets
After you read this chapter, you should be able to answer the following questions:
➤ What does it mean to say that capital markets are efficient?
➤ Why should capital markets be efficient?
➤ What factors contribute to an efficient market?
➤ Given the overall efficient market hypothesis (EMH), what are the three subhypotheses and what are the implications of each of them?
➤ How do you test the three efficient market subhypotheses and what are the results of the tests?
➤ For each set of tests, which results support the EMH and which results indicate an anomaly related to the hypothesis?
➤ What is behavioral finance and how does it relate to the EMH?
➤ What are some of the major findings of behavioral finance and what are the implications of these findings for the EMH?
➤ What are the implications of the test results for the following?
• Technical analysis
• Fundamental analysis
• Portfolio managers with superior analysts
• Portfolio managers with inferior analysts
➤ What is the evidence related to the EMH for markets in foreign countries?
An efficient capital marketis one in which security prices adjust rapidly to the arrival of new information and, therefore, the current prices of securities reflect all information about the secu- rity. Some of the most interesting and important academic research during the past 20 years has analyzed whether our capital markets are efficient. This extensive research is important because its results have significant real-world implications for investors and portfolio managers. In addi- tion, the question of whether capital markets are efficient is one of the most controversial areas in investment research. Recently, a new dimension has been added to the controversy because of the rapidly expanding research in behavioral finance that likewise has major implications regard- ing the concept of efficient capital markets.
Because of its importance and controversy, you need to understand the meaning of the terms efficient capital markets and the efficient market hypothesis (EMH). You should understand the analysis performed to test the EMH and the results of studies that either support or contradict the hypothesis. Finally, you should be aware of the implications of these results when you analyze alternative investments and work to construct a portfolio.
We are considering the topic of efficient capital markets at this point for two reasons. First, the prior discussion indicated how the capital markets function, so now it seems natural to con- sider the efficiency of the market in terms of how security prices react to new information. Sec- ond, the overall evidence on capital market efficiency is best described as mixed; some studies support the hypothesis, and others do not. The implications of these diverse results are important for you as an investor involved in analyzing securities and building a portfolio.
176
This chapter contains five major sections. The first discusses why we would expect capital markets to be efficient and the factors that contribute to an efficient market where the prices of securities reflect available information.
The efficient market hypothesis has been divided into three subhypotheses to facilitate testing.
The second section describes these three subhypotheses and the implications of each of them.
The third section is the largest section because it contains a discussion of the results of numer- ous studies. This review of the research reveals that a large body of evidence supports the EMH, but a growing number of other studies do not support the hypotheses.
In the fourth section, we discuss the concept of behavioral finance, the studies that have been done in this area related to efficient markets, and the conclusions as they relate to the EMH.
The final section discusses what these results imply for an investor who uses either technical analysis or fundamental analysis or what they mean for a portfolio manager who has access to superior or inferior analysts. We conclude with a brief discussion of the evidence for markets in foreign countries.