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Finer Points

How to Create a Custom Stock Index

02/14/2019

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A term you will sometimes hear in money management is construction. Investors can create a custom stock index to suit their personal objectives, taking some of the best aspects of pre-existing indices to make something personally applicable.
This article will discuss how to create a custom stock index, better explaining the factors that go into index construction and explaining the relative importance of each factor. Read on to learn more.

What is Stock Index Construction?

In finance terms, construction usually refers to the construction of a stock index. Indexes such as the S&P500 are constructed to include the top 500 equities in terms of market cap or trading volume, while other indexes vary their total number of holdings to maintain a certain market percentage.

A number of factors are considered when creating a stock index. Some of the factors that are considered include total market cap, number of shareholders, and total number of shares outstanding.

Methods of Stock Index Construction

Stock indexes are constructed in different ways with different goals in mind. That said, there are certain keys factors that are taken into consideration in the construction of each respective index.

Some of these factors will be discussed below.

Exclusionary vs Inclusionary Screens

For the larger or more prestigious indexes such as the S&P500 or the NASDAQ, stocks are forced to go through a number of different screening processes to ensure that the respective indexes are strong and meet certain standards.

There are typically two types of screening processes as it pertains to stock index construction: exclusionary and inclusionary. An exclusionary screen is slightly-less common, and would be primary used in conjunction with socially or environmentally-conscious indexes.

Many investors do not want to buy into companies that are excessively hard on the environment or participate in potentially-unethical business practices. This has become a term onto itself known as SRI (socially-responsible investing) or green investing.

Some stock indexes are constructed to exclude stocks that do not meet certain environmentally-conscious or ethical criteria. To wit, Standard & Poor has a side index called the S&P500 Environmental and Socially Responsible Index, which measures the performance of the 500 securities with the most social and environmental sustainability.

Socially-conscious investing is on the rise, and a wide number of socially-responsible funds have popped up in recent times. Contemporary investors want to see their investment capital put to good use, and as a result the construction of eco-friendly or socially-smart stock indexes and mutual funds has risen greatly.

While indexes that use exclusionary screens are on the rise, traditionally stock indexes have used inclusionary screens, which mandate that companies meet certain criteria to merit inclusion on a given index.

If you are looking to create a custom stock index. there are a number of screening tools available online for investors who are looking for a particular set of attributes from their stock basket.

Investors can sift through various indices by criteria such as price-per-share, daily trading volume, and more technical details such as performance within a 50-day moving range.

Using screening tools can allow an investor to create a custom stock index that perfectly aligns with her or his personal preferences, ethical concerns, and financial objectives.

Capitalization-Weighted Index Construction

As noted above, market cap is often a determining factor when constructing a stock index. There will always be a place at the table in most major indexes for mega-cap stocks such as Google and Microsoft. Indexes that work off of sheer market cap are known to be capitalization-weighted.

Stocks included at the top of a cap-weighted index tend to have more sway over the index on the whole. As an example, the S&P500 is a relatively-exclusive cap-weighted index, and the top four holdings within the index (Facebook, Apple, Microsoft, and Amazon) account for over 10% of the entire index.

Most investors believe that cap-weighted indexes best reflect the actual market, as the largest, most stable companies have the greatest influence on the index while smaller or growing companies determine the index’s movement and worth to a less-substantial degree.

Cap-weighted indexes are by definition top-heavy, and serve as a good gauge for the overall health of the market on the whole.

Price-Weighted Index Construction

In contrast to a cap-weighted index, a price-weighted index rises and falls with the current market prices of its constituent stocks. A stock with a higher market price will have much more impact on the entire index than a stock with a lower price-per-share, irrespective of total outstanding shares.

The most prominent price-weighted index is likely the Dow Jones index. The DJIA is quite exclusive, as it is composed of only 30 significant stocks rather than several hundred.

The main appeal of a price-weighed index is that it’s extremely simple and straightforward. The downside is that the movement of the higher-priced stocks can have a disproportionate effect on the index as a whole.

Cap-weighted indexes were created in large part to remedy this issue, and to give a more-accurate reflection of a current market.

Equal-Dollar Weighted Index Construction

Lastly, indexes can be constructed with equal-dollar weighting. While this construction method is fair and combats the issue of larger companies having greater sway, it does come with a few problems.

For example, to maintain equal-dollar weighting, an investor or trader would need to continuously flip stocks in the interest of maintaining equilibrium. This would of course come with increased trading fees and taxes.

Equal-dollar indexes also have the opposite problem of price-weighted indexes, in that smaller companies have a disproportionate drag on the entire index. This again distorts perception and gives an inaccurate depiction of a market’s health.

Factor-based indexes are emerging as a solution to all of the issues mentioned above, but many factor-based indexes are still in the research and theoretical stages. Financial experts also tend to argue the merits of different factors, leading to a lack of consensus in index construction.

Find the Best Approach to Create a Custom Stock Index

Any equity investor will want to diversify her or his portfolio, and it’s in the best interest of an investor to understand how each index is constructed. An investor can then create a custom stock index that meets her or his personal financial and investment objectives.

While each type of index comes with drawbacks, there are also merits to each type of index. Diversifying asset allocation between differently-constructed indexes, and in turn creating your own index, is smart money management.

Once an investor better understands what goes into an index’s construction, he or she can then determine which stock indexes to invest in, as well as how much to invest in each index.

Linden Thomas & Company

One of America’s Top Wealth Managers builds a better Index

At Linden Thomas, we believe most indexes focus on the wrong things like weighting the index based on the size of a company (market cap).

We agree with many long-term academic studies that continue to validate the importance of how quality earnings are directly connected to real equity performance…

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