AI for Trading Series №7: Stocks, Indices and Funds
By: Purva Singh
Tags: Index, Stocks, Investment Funds, Ai For Trading, Finance

AI for Trading Series №7: Stocks, Indices and Funds

Photo by Jamie Street on Unsplash

Index/Indices

Overview

Indices refer to an aggregated value of a group of stocks as a single number. For example, we have S&P500 and DJIA (Dow Jones Industrial Average) for USA, NIKKEI and HANG SENG for Asia and FTSE, EURO STOXX for Europe. These are all example of indices.

Indices are created by financial research and credit rating companies such as Standard and Poor’s, Dow Jones and Financial Times. They are published by stock exchanges such as Nasdaq or the London Stock Exchange.

Business news may refer to whether the index went up or down.

They are virtual profiles and are not actual funds that people invest in.

Indices track subgroups of the market, and may be designed specifically to track stocks in the same stock exchange, same country, or same sector.

Indices give investors a measure of the market’s status.

Professional investment managers may use indices as benchmarks against which they can evaluate their own fund’s performance.

Market Captialization

Consider a scenario where we want to to track only smaller companies or what if we just want to track only high-growth companies? Having a more specific index would definitely help if our investment research is focused on companies with similar characteristics.

The creators of index often make indices that group stocks by Market Capitalization defined as large-cap, mid-cap and small-cap.

Market Capitalization or “Market Cap” refers to the total dollar market value of a company’s outstanding shares of stock. It is calculated by multiplying the total number of a company’s outstanding shares by the current market price of one share.

For example, the S&P divides a list of stocks into the S&P 500, S&P MidCap 400 and the S&P SmallCap 600. The S&P 500 contains large-cap stocks such as Lockheed Martin, an aerospace company. The S&P MidCap 400 contains stocks such as Delphi, an automotive technology company. The S&P SmallCap 600 contains a small-cap stocks such as The New York Times. Now, within each of these indices, the stocks are then ranked as more growth or more value stocks.

Growth Stock v/s Value Stock

Indices can also include stocks based on whether companies are considered growth or value stocks.

Growth stock tends to have high growth is sales or earnings and have potential for future growth. For example, if a company creates new ways for people to commute from one place to another, it might be considered a growth stock due to its potential for increased future sales.

Values stock tends to be a matured company that has stable sales, revenue and earnings. So for example, a company that sells bathroom products will have a stable flow of earnings. But this company will have fewer expectations for a future rapid growth.

Continuing our S&P example as explained above, from the S&P SmallCap 600 list, stocks are selected for the S&P SmallCap 600 Growth Index or the S&P SmallCap 600 Value Index.

Ratios

In order to decide whether a particular company is growth or value we can look at valuation metrics such as price to earnings ratio, price to sales ratio and price to book ratio. Then, within a list of companies in an index, we can rank these stocks by these metrics and say that stock is more on one end of the spectrum relative to the other stocks.

Price to earnings ratio : the stock price divided by the company’s earnings per share over the past four quarters.

Price to sales ratio : the the stock price divided by the sales per share over the past four quarters.

Price to book ratio : the stock price divided by the book value per share. The book value is the company’s accounting value, which is assets minus liabilities.

Growth stocks tend to have high price to earnings, price to sales, and price to book ratios. Value stocks tend to have lower price to earnings, price to sales, and price to book ratios.

For example, in general, software and biotechnology stocks tend to have higher PE ratios, while agriculture and construction companies tend to have lower PE ratio.

Price Weighting and Market Cap Weighting

Consider the index NIKKEI 225, which tracks the price movements of 225 stocks. Now, in order to get a single index number, we can simply add up all the single share price of all the 225 stocks. This is called Price Weighting or Equal Weighting. Dow Jones Index is also price-weighted index.

We can also take weighted average of the stocks so that all the stocks are not treated the same. For example, we can give more weight to stocks of bigger companies rather than smaller companies because the movement of a larger company’s price will have more effect on the overall change in the stock market. This is called Market Cap Weighting. Major indices that follow market-capitalization weighting are the S&P500, Hang Seng, MERVAL, FTSE and EURO STOXX.

Adding or Removing Companies from an Index

In June 2018, Monsanto, a U.S. based agriculture company was acquired by Bayer, a German-based pharmaceutical company. Monsanto was listed in the S&P500, but after the acquisition, S&P500 removed Monsanto from the S&P500, which is called an index delete. S&P500 also added Twitter, which is called an index add.

Prior to its replacement, Monsanto was worth about $50 billion and Twitter was worth about $30 billion. Now, lets consider an imaginary company, X, that serves as a placeholder for Monsanto before change and Twitter after the change. Next, we calculate the percentage change in X’s market cap from $50 billion to $30 billion and apply that to the previous index to get current day’s index.