The Trouble With Indexes

Nortel melts down and so does the TSE 300

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We've got trouble! Right here in Index City! And that starts with T and that rhymes with P and that stands for proportional (market cap based) weighting.

The TSE 300 took a beating Wednesday. Less than an hour and a half after the market opened it hit its low point for the day - off a staggering 956.7 points, though it recovered slightly to close at 9511.8, down 840.3 or 8.12%. It was the single largest one day point drop in TSE history and the second largest in percentage terms. And the reason for that beating, of course, was Nortel - Canada's gorilla tech stock.

Nortel is Canada's largest company by market capitalization. And because the TSE 300 is weighted by market cap, Nortel, even though it is just one of 300 stocks making up the index, accounts for a third of it. And its plunge accounted 794 of the 840 point drop in the TSE 300. Now I ask you - is that right?

Consider the anomalies - the TSE 300 would have gone down significantly Wednesday even if every stock in the index went up except for Nortel with its 25% drop. Conversely, the index has often gone up during the past year in spite of decliners leading advancers because Nortel went up.

This awesome weighting has created headaches for more than a few managers of Canadian Index funds. Should they underweight Nortel to have a more balanced portfolio? Or accurately represent the index but be out of balance?

The rationale for a weighted index is that it reflects the economy. There's x billion dollars worth of companies out there. And the index reflects how that changes.

But investors want to know how the stock market is doing, not whether the aggregate market cap of all the companies in the economy is growing or shrinking. We want to know whether stocks in general are going up or down.

An individual investor will not spread his investments around according to market cap. He won't buy more of company "A" because it's a bigger company than company "B". So why should a market average be calculated that way?

But not all stock indexes are measured this way. Consider the Dow Jones Industrial Average. As originally conceived and developed by Charles H. Dow, the DJIA was calculated by taking the average price of the ten original stocks making up the index.

Now we might say that Dow was not as sophisticated as we are when he launched the Index on May 26, 1896. Nevertheless, his index remains true to its original roots to this day and it remains the single most respected and trusted index in the world.

The Dow, to be sure, has changed. In 1896 Dow took ten stocks, added their prices together and divided by ten. Simple. Elegant. Easy to understand. The only change made has been to the divisor to reflect stock splits. For example, a three stock index calculated on prices of $5, $10 and $15 works out to an average of 10. If the $15 stock splits 3 for 1, the divisor must change if the average is to remain the same. In this case, the divisor becomes 2 instead of 3. The average remains 10.

The only other changes are the makeup of the index itself. The number of stocks increased to 30 and old companies are occasionally dropped from the index and replaced by new additions. But the index remains an average of the stock prices of the companies comprising the index adjusted for stock splits.

Another index that doesn't follow the weighting system is the CDNX Composite Index. Launched on November 29, 1999 with an initial value of 2000, the CDNX is calculated by increasing or decreasing the index by the average percentage change of all the stocks in the index.

The stocks comprising the index are chosen by market cap (the top 80% of stocks traded on the CDNX by market cap) but the calculation of the daily changes has nothing to do with market cap. In fact, companies can be added to or deleted from the list, as they are every quarter, with no problems in making the calculations. Click on the link to CDNX Index Explained in the box above right for the formula.

But aside from the Dow and the CDNX Composite, all the other major indexes are based on market cap. See the table below for details.

Canadian Internet Index

When I first created my Canadian Internet Index in 1999 I invented an entirely new way of doing an index. I hypothesized an investment of $1000 in each stock in the index on day 1. Then I simply divided the value of such a portfolio by the number of stocks to calculate the index.

Because there had been so many additions to the index during 1999, I decided to reconstruct the index for January 1, 2000 with a set list of 60 stocks to be reviewed annually. I was going to follow the same procedure as the previous year, but was persuaded that a "fully-weighted" index was more professional. So I made it fully weighted.

In retrospect, I should have stuck to the original plan. I'll revert to it for 2001 if I decide to continue with the index.

In the meantime, what do you think of the various ways of calculating an index? There are two polls below to get your view on indexes and how they are calculated.