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Stock Indexes Explained - Hidden biases - Price, Market Cap, Fundamental, and Equal Weighting - YouTube
Channel: Paul Sitarz
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Hey, whatâs up?
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Itâs Paul.
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In this video, I will show you that stock
indexes have biases that matter for your investments.
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One of the most given advice to new stock
marketâs investors, and it is also true
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for seasoned investors, is to invest in an
index, like the S&P 500 or the Dow Jones,
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by using exchange-traded funds.
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It is not only cheap, but it also reduces
the risks of investing because you benefit
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from the inherent diversification of the index.
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However, do you know that all indexes are
not equals?
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Some indexes have biases you are not aware
of!
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I am not talking about a bias toward a particular
industry, like the Nasdaq, which is more oriented
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toward technology stocks.
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No, I am talking about something way more
subtle than that.
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There are multiple ways to create an index,
and professional investors are aware of how
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an index is built since it affects their investments.
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Let me unveil for you a hidden aspect of indexes.
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If you want to get more videos on finance,
subscribe and give me a thumbs-up.
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It really helps this channel to grow.
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Did you ask yourself how the index you are
investing in is built?
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Probably not.
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You may be surprised by it, but there are
multiple ways to create an index, and the
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two major indexes in the U.S., the Dow Jones
Industrial Average and the S&P 500 are very
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dissimilar!
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Not only in the number of stocks each index
has, but each indexâs essence is different.
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Let imagine the Dow Jones with precisely the
same constituent stocks as the S&P 500.
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Even that way, the Dow Jones would have a
different performance!
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Why?
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Because the Dow Jones is a price-weighted
index, whereas the S&P is a market-capitalization-weighted
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index.
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And there are even other methods, equal weighting,
and fundamental weighting!
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Letâs start with the price weighting.
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It is one of the earliest methods due to its
simplicity.
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Charles Dow used it when he created the Dow
Jones Industrial Average on May 26, 1896.
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With price weighting, the most important thing
is the price.
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The percentage of each stock in the index
is determined by the ratio of the stock price
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divided by the sum of all stocksâ prices.
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Imagine we are building a price-weighted index
with ten stocks, and the sum of all stock
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prices is $1000.
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We have the stock of a huge company, the company
âA,â which has earnings in billions.
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However, âAâ emitted a lot of shares.
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Stock âAâ is diluted and has a low price,
and it trades at $10.
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Then this stock will constitute 1% of the
index.
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The business âB,â which is smaller, its
earnings are expressed in millions, has, on
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the other hand, emitted a small number of
shares, so its stock trades at $750.
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In our price-weighted index, the stock âBâ
will weigh 75%!
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Now you see the big issue of price-weighted
indexes, like the Dow Jones Industrial Average,
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they do not necessarily represent the economic
activity, nor the stock market performance,
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because they ignore the companiesâ sizes
and the weights are somewhat arbitrary.
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A higher-priced stock will have a more substantial
impact on the index value than a lower-priced
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stock.
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If stock âAâ soars by 10% to $11, but
at the same time stock âB,â loses a mere
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$1, a 0.13% decline, our index does not move
at all!
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Another unique characteristic of price weighting
is that in its purest form, a price-weighted
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index will jump when companies do stock splits
and stock consolidations (also known as reverse
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stock splits).
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With our example, imagine the company âBâ
decides that $750 for its stock is too high,
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as it has an impact on the liquidity of its
stock.
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It chooses to do a stock split, for each share
an investor owns, he now has three shares.
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The board of the company âBâ increased
the total number of outstanding shares threefold,
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while at the same time dividing the stock
price by three to $250.
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The value of the company did not change.
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If our index was at 1000, its level will instantaneously
go down to 500.
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Though in the real economy nothing happened!
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Now, the stock âBâ weighs only 50%.
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All other stocks will have their weights increase,
for example, the stock âAâ will jump from
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1% of our index to 2%.
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If you start to be frightened by price-weighted
indexes, I will clarify one thing: the Dow
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Jones Industrial Average is not the purest
form of a price-weighted index.
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Stock splits and consolidations do not move
the index, because weights are attributed
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relative to another number, the Dow divisor,
which prevents jumps for corporate actions
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such as splits and consolidations.
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A new divisor is calculated every time a stock
split happens, so the index value is not impacted.
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Another well-known price-weighted index is
the Nikkei 225, which is the leading Japanese
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index.
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It is composed of the top 225 Japanâs companies
on the Tokyo Stock Exchange.
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Overall, the primary bias of price-weighted
indexes, like the Dow Jones Industrial Average,
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is toward higher-priced stocks.
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Equal weighting is another simple alternative.
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In this case, it is elementary!
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Each stock has the same weight.
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For a ten stock index, every stock weighs
10%.
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Some indexes are built that way.
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Also, you can easily find ETFs tracking equal-weighted
versions of the Dow Jones and the S&P 500.
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This kind of weighting scheme is strongly
biased toward small-caps stocks since their
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index weights are much higher than their importance
in the economy.
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Small-caps are overrepresented, while corporate
giants are underrepresented.
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In the long run, it should provide higher
returns because small-caps usually have higher
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potential returns than large-caps, but it
comes at the price of higher risks since small-caps
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stocks are generally more volatile than large
caps.
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Another drawback of equal weighting is that
prices donât stay the same, and frequent
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adjustments are necessary.
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Hence equal-weighted ETFs incur higher transaction
costs than market-cap weighted index funds.
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This higher volume of trading is causing a
higher portfolio turnover, which is tax-inefficient.
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Can you guess what the other colossal bias
of equal-weighting is?
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An equal-weighted index has a âcontrarianâ
bias.
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It does the opposite of what other market
participants are doing!
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If a stock âAâ is performing well because
there is an immense buying pressure, an equal-weighted
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ETF will, on the contrary, sell the stock
âA.â The opposite is also true.
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If a stock âBâ is out of favor, his price
tumbling down, the ETF will buy it!
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An equal-weighted index and ETFs replicating
it are doing the opposite of other market
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participantsâ consensus!
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Isnât it something every buyer of that kind
of ETF should be aware of?
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I do think so!
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Letâs focus now on the major weighting scheme:
the market-capitalization weighting.
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The idea here is to have an index that represents
the importance of the companies in the economy
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and the stock market.
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A market-capitalization-weighted index will
take the stock price, multiply it by the number
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of shares, which gives us the capitalization
of the company and divide it by the sum of
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the capitalization of all companies in the
index.
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Hence a small-cap will get a small weight
and a large-cap a high weight.
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However, usually, market-capitalization indexes
go one step further.
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All the shares of a company are not available
to the general investing public.
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So to take it into account, those indexes
focus on the number of shares the investing
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public can freely exchange, which is called
the free-float.
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Index providers replace the total number of
shares of the previous calculation by the
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free-float, which now gives us the âmarket
float,â the total capitalization available
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to the investing public.
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They are âfree-float-adjusted market-capitalization-weighted
indexes.â
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To name some major indexes built that way,
we have the S&P 500 in the U.S. or the Dow
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Jones EuroStoxx 50 in Europe.
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Global indexes may go even further by considering
the number of shares available to foreign
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investors to compute the weights of each constituent
stock.
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It is the perfect weighting scheme, isnât
it?
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You get the best representation of the stock
market, donât you?
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It is more complicated than it looks.
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You get a fair representation of the target
market, but you also have a strong âmomentumâ
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bias.
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When a stock price rises, all else equals,
the weight of that stock increases in the
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index, and if it falls, the weight decreases.
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You buy more of a soaring stock, and you sell
poor performers.
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You follow the momentum of each stock.
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It is the exact contrary of the equal-weighting
scheme.
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To correct that momentum bias, some index
providers create fundamentally-weighted indexes.
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Instead of using the price as one of the main
drivers of the constituentsâ weights, these
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indexes use fundamental factors to assess
the companyâs size, like the companyâs
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book value, cash flows, earnings, total sales,
total cash dividends, or other relevant factors.
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It effectively removes the momentum bias,
to introduce a âvalueâ tilt.
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Check out my video on Warren Buffettâs 2020
vision; I briefly explain the difference between
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growth and value investing styles; the link
is in the description.
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In a word, fundamentally-weighted indexes
favor companies that are low-priced relative
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to their earnings.
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It also means that those indexes have a âcontrarianâ
bias since they will weigh more heavily a
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stock that has declined more in price than
its fundamental value, hence increased its
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relative value.
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And if a stock price soared, and the fundamental
value did not move up by the same magnitude,
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the relative value of this particular stock
declined, its weight will be adjusted downward.
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To come back to the advice to invest in an
index by using exchange-traded funds.
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It is a good one, but now you know that all
indexes are not the same, and you now understand
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how to choose an index that fits your investment
preferences.
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Question of the day: Do you invest in an index?
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Which one?
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And why?
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If you have been getting value out of this
video, subscribe and smash the like button!
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Thank you for watching, and see you soon for
my next video!
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