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> Stock indices, baskets and portfolios
post Feb 5 2007, 09:48 PM
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Stock indices, baskets and portfolios

While these terms are often used interchangeably, there are a number of characteristics which distinguish these terms, and distinguish specific variations within each entity described by these terms. A synopsis of these distinctions is given below.

A stock basket and a stock index refer to the same conceptual thing – an aggregate of individual securities. A "custom basket" and "custom index" also refer to the same conceptual thing, with the added distinction of being a non-listed derivative instrument, and therefore includes the concept portfolio. In order to eliminate confusion, I attempt to always use the term 'custom basket' for non-listed, custom stock aggregations (baskets, portfolios), and 'index' for listed stock and sector indexes. There are certain legal differences that pertain to listing, and there are tax differences from the different taxation rates for dividends vs. cap gains, that is, if the index/basket is constructed as a total return index, pass-through index or price level only. There are other indices which refer to non-stock references, such as yield indices, inflation indices and volatility indices. Many of these serve as the reference for tradeable derivative instruments.

A stock basket or index generally refers to a specifically defined aggregation of stocks, with dividend payments a separately defined attribute within the definition of the basket. One of the terms necessary in defining any stock basket or index is whether the instrument is a constructed as total return basket or market level basket; a total return index or a market level contract (or other more complex delimiters).
As to the dividend payment, the index value changes according to how it is defined above, i.e. in a total return index, the index level(value) is changed for dividends (dividends are added), for a more common, market level index (non-total return) index (SP500), dividends are not calculated into or out of the index level. Indices and baskets designed as pass-thru contracts will payout the dividend "when paid" and retain the index reference level in the same way as a market level index.

Other distinctions among indices are whether they are cap-weighted, equal weighted, market-share weighted or price weighted, such as the DJ industrial 30.

A cap-weighted stock index is weighted by the market capitalization of each stock in the index. In such a weighting scheme, larger companies account for a greater portion of the index. Most indexes are constructed in this manner, with the best example being the S&P 500. For example, if a company's market capitalization is $1,000,000 and the market capitalization of all stocks in the index is $100,000,000, then the company would be worth 1% of the index.

In a market-share weighted index, price is weighted relative to the number of shares, rather than their total value. Traditionally, capitalization- or share-weighted indices all had a full weighting i.e. all outstanding shares where included. Recently, many of them have changed to a float-adjusted weighting.

A price-weighted index such as the DJ industrial 30 compensates for stock splits and other adjustments, with the creation of a divisor that is periodically adjusted.

Listed indices may be calculated if all the determinants of the index – the stocks included, their weightings and divisors – are in the public domain, but some indices, such as the NASDAQ do not publish these. All listed indices are assigned a security identifier (e.g. CUSIP) as part of the listing process, and often have a generally accepted ticker ($XAU.X). They often serve as the basis for various other derivatives, such as options and futures, with codified “root” identifiers, whereas custom baskets and portfolios usually do not (e.g., an unlisted custom basket may not have a CUSIP, but a traded derivative product based on that basket, such as a linked note, will).

Due to these distinctions, different kinds of information pertaining to the make-up of the basket or index will need to be retained in order to accurately represent the instrument, and in most cases of listed indices, the issuer will be the final authority as to pricing, components, construction and other important characteristics of the derivative – and must be referenced for various events, including the common periodic rebalancing of a listed index, and changes to the divisor, and special dividend treatment.

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