Equity Index Funds: Source and Direction of Biases

Source and Direction of Biases

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Question

Tamber Benz, CFA, recently joined Bay Area Investment Group as a personal financial planner. Today, she has a meeting with a client interested in equity index funds, with a particular interest in learning about the source and direction of biases. In preparation for this meeting, she makes some quick notes (relying on her memory). These notes are listed below. She then finds her well-worn CFA study notes and checks her memory. After reviewing her notes, which of the following choices does she determine is INCORRECT?

Answers

A. The Dow Jones Industrial Index has a built-in downward bias.

B. An index such as the Valueline Composite Average is constructed by purchasing an equal number of shares of each stock in the index, and will have a downward bias when geometric averaging is used to compute the return.

C. One problem with an index such as the S&P 500 is that firms with greater market capitalization have more impact than other firms.

D. A market value-weighted index, such as the New York Stock Exchange Index, accurately reflects the impact of price changes on wealth.

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Explanations

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A. B. C. D.

Although the latter part of this statement is correct, the first part is incorrect. The Valueline Composite Average is an unweighted price indicator series, and is constructed by maintaining an equal dollar investment in each stock in the index. The return of an unweighted index is usually calculated using a geometric average. Assuming the existence of volatility, the geometric average will always be lower than the arithmetic average.

The other statements are true. The Dow Jones Industrial Index is a price-weighted index and thus has a built-in downward bias because of the impact of stock splits. After a stock split, the denominator is adjusted downward to keep the index at the same level as before the split. Since high-growth companies tend to announce stock splits more frequently than low-growth companies, the larger, more successful firms lose influence on the index. The S&P 500 index is a market- value weighted index. One problem with market-value weighted indexes is that firms with greater market capitalization have more impact than other firms. If these firms also have higher returns, the firms can dominate the index.

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