A study on sector index of stock market proposal for development of FPTS sector index

This thesis ―A study on sector index of stock market and proposal for development of FPTS sector index‖ is aimed at give out a detailed proposal for the development of FPTS sector indice

Nguyen Minh Khoi

A STUDY ON SECTOR INDEX OF STOCK MARKET

PROPOSAL FOR DEVELOPMENT OF

FPTS SECTOR INDEX

master of business administration thesis

Nguyen Minh Khoi

A STUDY ON SECTOR INDEX OF STOCK MARKET

PROPOSAL FOR DEVELOPMENT OF

1 DR TRAN doan Kim

2 Tran Phuong Lan, MBA, Ph.D candidate

Hanoi - 2008

TÓM TẮT ii

ACKNOWLEDGEMENTS iii

TABLE OF CONTENTS iv

List of figures viii

List of tables viii

List of equations ix

INTRODUCTION 1

1.1 Research problem 1

1.2 Objectives &Aims 1

1.2.1 Objectives 1

1.2.2 Aims 1

1.3 Research question: 2

1.4 Method/Approaches 2

1.5 Scope of work 2

1.6 Data resources 2

1.7 Method 3

1.8 Significance 3

1.9 Limitations 3

1.10 Expected result: 3

1.11 Follow – up (potential) 4

1.12 Short introductions 4

1.12.1 Chapter 1: Theory foundation 4

1.12.2 Chapter 2: Analysis of sector indices 4

1.12.3 Chapter 3: proposal for developing FPTS sector index 5

Chapter 1: THEORY FOUNDATION 6

1.1 Introduction 6

1.1.1 Definition of market index and sector index 6

1.1.2 Type of market indices 6

1.1.2.1 By industry (Sector indices) 7

1.1.2.2 By geographic location 7

1.1.2.3 By the nature of index members 7

1.2 Sector index applications 8

1.2.1 Sector monitoring and determining sector trend 8

1.2.2 Creation of index-linked investment products 9

1.2.3 Precise asset allocations 9

1.2.4 Hedge economic risk 9

1.2.5 Sector investing 10

1.2.5.1 Increase returns and reduce the overall risk of a diversified portfolio 10 1.2.5.2 Take advantage of long-term trends 10

1.3 Sector indices calculation 11

1.3.1 Step 1: Calculation methods 11

1.3.1.1 Passcher method 11

1.3.1.2 Laspeyres method 12

1.3.1.3 Fisher method 12

1.3.1.4 Simple arithmetic price average 13

1.3.1.5 Simple geometric price average method 13

1.3.1.6 Comparison of index calculation method 14

1.3.2 Step 2: Members selection 14

1.3.3 Step 3: Divisor adjustment 15

1.3.3.1 Reasons for divisor adjustment 15

1.3.3.2 Divisor adjustment formula 16

1.3.3.3 Timing of divisor adjustments 17

1.3.4 Step 4: Index calculation 18

Chapter 2: ANALYSIS OF SECTOR INDICES 19

2.1 Analysis of international sector indices 19

2.1.1 S&P select industry indices 19

2.1.1.1 Index Description 19

2.1.1.2 Sector classification system 19

2.1.1.3 Index membership 19

2.1.1.4 Index calculation 21

2.1.2 Dow Jones U.S Industry Indices 22

2.1.2.1 Index description 22

2.1.2.2 Sector classification system 22

2.1.2.3 Index membership 23

2.1.3.2 Sector classification system 24

2.1.3.3 Index membership 24

2.1.3.4 Index calculation 25

2.1.4 MorningStar sector Indices 26

2.1.4.1 Index description 26

2.1.4.2 Sector classification system 26

2.1.4.3 Index membership 27

2.1.4.4 Index calculation 28

2.1.5 NYSE Sector Indices 29

2.1.5.1 Index description and sector classification system 29

2.1.5.2 Index membership 30

2.1.5.3 Index calculation 31

2.1.6 Comparison and conclusion of international sector indices 32

2.1.6.1 Comparison 32

2.1.6.2 Conclusion 33

2.2 Analysis of local sector indices 34

2.2.1 VN – Index and HASTC Index 34

2.2.1.1 Index description 34

2.2.1.2 Index membership and calculation 35

2.2.2 CBV Index 37

2.2.2.1 Index description 37

2.2.2.2 Index Membership 40

2.2.2.3 Index calculation 42

2.2.3 DC 30 Index 43

2.2.3.1 Index introduction 43

2.2.3.2 Index membership and calculation 44

2.2.4 Thang Long 20, 30 Index 46

2.2.4.1 Index description 46

2.2.4.2 Index Membership 46

2.2.4.3 Index calculation 47

2.2.5 SSI 30 Index 48

2.2.5.1 Index description 48

2.2.7.2 Additional drawbacks of other local index 54

Chapter 3: PROPOSAL FOR DEVELOPING FPTS SECTOR INDEX 55

3.1 Introduction and Objectives 55

3.2 Methodology 55

3.2.1 Sector classification system 55

3.2.2 Base value and base date 56

3.2.3 Weighting scheme 56

3.2.4 Index formula 56

3.2.5 Data sources 57

3.3 Index memberships 58

3.3.1 Index eligibilities 58

3.3.2 Additions to and deletions from FPTS sector indices 59

3.3.2.1 Additions to FPTS sector indices 59

3.3.2.2 Deletions from FPTS sector indices 60

3.3.3 Member selection flowchart 61

3.4 User requirement description (URD) 62

3.4.1 Back-end user requirements 62

3.4.2 Front –end user interface and functionalities 62

3.4.2.1 Page layout and elements 63

3.4.2.2 Prototype of FPTS sector index homepage 64

3.4.2.3 Prototype of FPTS sector index sectorpage 65

3.4.2.4 Prototype of FPTS sector member page 66

CONCLUSION 67

REFERENCES 68

Figure 2.1: Summary of Morningstar sector index family 27

Figure 2.2: CBV Index family 37

Figure 2.3: CBV Sector Index family 39

Figure 2.4: DC VN30 Domestic performance vs VNINDEX 44

Figure 2.5: DC VN30 Foreign performance again 44

Figure 2.6: SSI 30 performance in 2007 49

Figure 3.1: Procedure to select stocks to FPTS sector index 61

Figure 3.2: Page layout of FPTS sector indices pages 63

Figure 3.3: Prototype of FPTS sector index homepage 64

Figure 3.4: Prototype of FPTS sector index sector page 65

Figure 3.5: Prototype of FPTS sector member page 66

List of tables Table 1.1: Divisor adjustment formula table 16

Table 2.1: Comparison of international sector indices 32

Table 2.2: Top 10 companies in DC VN30 45

Table 2.3: Thanglong Index scoring table 47

Table 2.4: Local indices comparison 50

Table 3.1: Major element and content of FPTS sector indices 63

Equation 1.2: Laspeyres method formula 12

Equation 1.3: Fisher method formula 13

Equation 1.4: Simple arithmetic price average formula 13

Equation 1.5: Simple geometric price average formula 13

Equation 1.6: Index calculation formula 18

INTRODUCTION

1.1 Research problem

One of the most widely used tools to track industry or sector performance in the securities market is sector indices These are the essential tools for investors to follow up sector movements as well as to see the trend in those movements However, the securities market of Vietnam still lacks of an comprehensive and effective sector indices tools since the official market indices of the securities market of Vietnam (VN-Index and HASTC-Index) are to measure the overall market performance rather than any particular sector This thesis ―A study on sector index of stock market and proposal for development of FPTS sector index‖ is aimed at give out a detailed proposal for the development of FPTS sector indices

1.2 Objectives &Aims

1.2.1 Objectives

 Study sector index definitions

 Study sector index application and calculation methodology

 Compare and analyze most known international and local sector indices

1.2.2 Aims

Give out detailed proposals for the development of FPTS sector index family

1.3 Research question:

In order to achieve the objectives of the thesis, the author of thesis will try to answer the following questions:

 What are definition, types and applications of sector indices?

 What are the calculation methods of sector indices?

 What are the most known international and local sector indices? What are the differences and similarities among them?

 How to select members of FPTS sector indices?

 How to calculate FPTS sector indices?

 What are the core FPTS sector back-end functionalities and frond-end interfaces (user requirement description)?

 White paper, published methodology and other available documents on

websites of international and domestic indices

 Other resources: Internet forum, Google searches…

On the practice, it gives a detailed proposal to develop FPTS sector indices for FPT Securities Company including both methodology, back-end and front-end design and functions This is a good example and reference for any new sector indices

1.10 Expected result:

The study expects to show the following findings:

 Bring systematic knowledge about indices and sector indices

 Provide a deep analysis of popular international and local sector indices

 Develop a detailed proposal of FPTS sector indices for FPT Securities Company This proposal can also be considered as a specimen for other new sector indices

1.11 Follow – up (potential)

Further study can also be carried out to fine-tune the backend functions and front-end user interface and functions after the official launch of FPTS sector indices and receiving the feedbacks from FPTS clients

1.12 Short introductions

Due to the standardized thesis format and for the sake of clarity, after the introduction to its topic, this thesis is divided into three chapters as follows:

This chapter presents to the reader what other authors have written on the chosen subjects, which cover mainly definition, types, applications and calculation of sector indices The chapter seeks to give the topic depth and perspective, and further establish a basis on which the analysis is built

This chapter analyzes the most 5 international and local well-known sector indices in term of index description, membership requirements, sector classification and calculations A detailed comparison of the two groups are also presented

1.12.3 Chapter 3: proposal for developing FPTS sector index

This chapter, after listing the objectives of developing FPTS sector indices, presents detailed proposal for FPTS sector indices methodology, membership requirements and user requirement description for FPTS sector indices

Chapter 1: THEORY FOUNDATION

1.1 Introduction

1.1.1 Definition of market index and sector index

According to Wikipedia: ―In economics and finance, an index is a single number calculated from a set of prices or of quantities Examples are a price index, a quantity index (such as real GDP), a market performance Index (such as a labor market index / job index or a stock market index) Values of the index in successive periods (days, years, etc.) summarize level of the activity over time or across economic units (regions, countries, etc.)‖

According to Standard and Poor’s: ―An index is a single descriptive statistic that summarizes the relative change in an underlying group of variables‖ In case of a securities market index, that underlying variables are prices of securities available in the market including stock, bond,

derivatives (Important note: in the context of this thesis, the term “market

index” is also referred to as “securities market index” and can be used exchangeably) A market index is designed to measure price changes of an

overall securities market A sector index is a market index which is designed

to measure the performance of a distinct industry sector

1.1.2 Type of market indices

Over time, many indices have been created, maintained and improved

by financial institutions in the world Indices can be classified by many characteristics of indices These characteristics groups indices into groups for the purpose of classification These characteristics include but not limited to:

1 Sector or industry of index members

2 Geographic location: where the members of indices resides

3 The nature of index members: whether they are equity, bond or commodity

4 Market capitalization or size of index members

5 Style (value or growth) of index members

6 Dividend payout ratio of its stock members

1.1.2.1 By industry (Sector indices)

When in an index includes all (or representatives) stocks of an industry

or sector, that index is a sector index and measures the performance of its industry sector

1.1.2.3 By the nature of index members

1 Equity index: track the performance of equity securities

2 Bond indices: track the performance of bond markets (by broad market,

by sectors and term structure)

3 Commodity indices: include indices that employ different strategic

combinations of commodity futures

1.1.2.4 By market capitalization (size)

Stock groups are categorized by their market capitalization These include large cap, mid cap and small cap indices

1.1.2.5 By style (value or growth)

The style of an index is the style of its stock members which are often based on price to book ratio Price to book ratio of a stock is its share price divided by its common equity

1.1.2.6 By dividend (dividend indices)

Dividend indices contain all dividend-paying stocks that pay dividends consistently and sustainably or dividend leaders’ indices that include the highest yielding

1.1.2.7 By combination of the above characteristics

An index can have combination of the above-said characteristics For example: the combination of composite style indices and capitalization indices such as large-value indices and small-growth indices

1.2 Sector index applications

Sector indices have become vital investment tools for professional investors Main applications of sector indices include:

1.2.1 Sector monitoring and determining sector trend

Using sector index values, investors can quickly grasp sector performance and shifting patterns A sector index acts as a proxy for the aggregate price changes of all of the stocks which make up that sector and, as

a result, measures the price direction or volatility of the particular sector

Sector indices are updated frequently throughout each trading day so that trends in market price movements can be quickly seen, thereby enabling trading decisions (i.e buy, sell or hold at any particular time) to be made expeditiously

1.2.2 Creation of index-linked investment products

Data and insights from a particular sector are inputs to support the creation of index-linked investment products such as mutual funds and derivatives etc

1.2.3 Precise asset allocations

Because there are distinct indices for each investment style, investors could determine the corresponding portfolio risks and make precise asset allocations accordingly

1.2.4 Hedge economic risk

Just like stocks, each sector has its own characteristics For example, certain sectors can be characterized as defensive or cyclical in nature Defensive sectors are less affected by recessions and economic adversity The utilities sector (gas, electricity) is considered defensive as demand for this sector is stable and independent of the state of the economy Conversely, cyclical sectors (for example the consumer discretionary sector which includes goods like automobiles and refrigerators etc) generate high profits in

a prosperous economy but low profits as the economy degrades Besides, certain sectors are more interest-rate sensitive than others (such as financial services, banking, real estate and construction)

Therefore, recognizing these sector characteristics enables investors to handpick sectors and combine them in the most efficient way in their portfolios to achieve their investment goals

1.2.5 Sector investing

Sector indices are attached great importance and widely used to support sector investing Sector investing is a relatively popular investment strategy This strategy is most appropriate for those who have a diversified portfolio, a long-term investment outlook and are comfortable with the risks associated with equity investing Sector investing could bring the following benefits:

1.2.5.1 Increase returns and reduce the overall risk of a diversified portfolio

Research has shown that adding a sector investing strategy in a diversified portfolio may not only increase returns but also reduce overall risk

of the portfolio, since some sectors such as energy, utilities and real estate etc have low-to-moderate correlations with the overall market

1.2.5.2 Take advantage of long-term trends

With sector investing strategy, investors could make huge profits if they correctly anticipate long-term trends of the sector For example, if investors correctly forecast that there would be a large aging population of baby boomers in the United Kingdom, the United States, Canada and Australia after the post- world war II baby boom, they could benefit from investing in the healthcare sector because there would be an increased need for healthcare products and services by baby boomers in the future

1.3 Sector indices calculation

The calculation of sector indices comprises of four steps

Figure 1.1: Steps to calculate indices includes 4 major steps

1.3.1 Step 1: Calculation methods

Currently, there are 5 popular sector index calculation methods:

1.3.1.1 Passcher method

This is a weighted average index in which the weighting factor is the number of share outstanding in the period of calculation Passcher is the most popular method and also referred to as market capitalization weighted index

Equation 1.1: Passcher method formula

In which: Ip: Passcher market price index

Pt: Price at the time of t (reporting period)

P0: Price at the base time (t =0)

Qt: Quantity (weighting factor) at the time of calculation (t)

The indices KOSPI (Korea); S&P500(USA); FT-SE 100 (Britain) ; TOPIX (Japan) ; CAC (France); TSE (Taiwan); Hangseng (Hong Kong);

Swish indices,… and Vn-Index and HASTC-Index of Vietnam apply this method

1.3.1.2 Laspeyres method

This is a weighted average index with the weighting factor is the number

of share outstanding in the period of calculation

Laspeyres price average index is a weighted average index in which the weighting factor is the number of share outstanding in the base period Consequently, the calculation result depends on the proportion of outstanding shares in the base period

Equation 1.2: Laspeyres method formula

In which: IL: Laspeyres average price index

Pt: price at time of t (reporting period)

P0: price at the base period (t =0)

Q0: Quantity or the outstanding shares (weighting factor) at the base period (t=0)

There are few countries applying this Laspeyres method including German FAZ and DAX

1.3.1.3 Fisher method

Fisher average price index is the geometric mean between Passcher average price index and Laspeyres average price index This method overcomes the weaknesses of the two above methods since its result depends both on the weighting factors at both base period and calculation period

Equation 1.3: Fisher method formula

In which: I f: Fisher average price index

I p: Passcher average price index

I l: Laspeyres average price index

In theory, this method is available, but in fact, no country has applied this method

1.3.1.4 Simple arithmetic price average

Beside the above methods, the simple arithmetic average price index is also popular The formula is simple: the total sum of stock price is divided by the number of stocks included

Equation 1.4: Simple arithmetic price average formula

In which: Ip: simple arithmetic price average

Pi: price of stock i n: number of stock included in the indexThe Dow Jone index family of the USA, Nikkei 255 of Japan, and MBI of Italia apply this method This method is appropriate when the price of stocks listed is relatively near one another or in other word; their standard deviation ()

is low

1.3.1.5 Simple geometric price average method

Equation 1.5: Simple geometric price average formula

In which: Ip: simple geometric price average

Pi: price of stock i n: number of stock included in the index

This method is only advisable when the standard deviation of the stocks included is relatively high The indices Value line (USA); FT-30 (Britain) apply this method

1.3.1.6 Comparison of index calculation method

It is very hard to say which index calculation method is better than other method in general The choice of calculation method depends on the purpose of each index, the popularity of each method and is subject to the decision of the index developers However, Passcher method or market capitalization weighted method is becoming increasingly popular nowadays since it reflects the ―relative importance‖ of one stock via its market capitalization as the weighting factor

1.3.2 Step 2: Members selection

The second important step in building average price index is the selection of index members The New York stock exchange includes more than 3000 stocks while Dow Jone composite comprises of only 65 stocks in which Dow Jones Industrial Average (DJIA) has only 30, Dow Jones Transportation Average (ADTA) only 20 and Dow Jones Utilities Average (AJUA) only 15 Although, including only a small number of member stocks, the Dow Jones index family still lasts for long because it reflects trend, development of the overall price movement The index members are

representative for the population since the non-representative members of indices are replaced by more representative ones For example, in November,

1999, four members of DJIA were replaced

As for Vietnam or any emerging market, since the number of stock listed has not been large, the market index should include all listed stocks However, the trading quantity and volume should also be taken into account

If one stock has no trading or every limited quantity for a long time, it should

be expelled from the index The purpose of that action is to make sure that the index can reflect the fair movement of the market prices

1.3.3 Step 3: Divisor adjustment

1.3.3.1 Reasons for divisor adjustment

During the continuous calculation of a sector index, some factors that change the quantity and value of stocks will affect the continuity of the index The factors include inclusion, exclusion of index members, replacement of index members, stock split or merger, stock dividend, cash dividend, additional issuance, stock warrant, stock price adjustment on ex-right date….To negate for distortions caused by those factors so that the average price index only reflects the changes in stock price, the index divisor adjustment is needed

The following formula will be used for divisor adjustments due to

corporate action (Note: No divisor adjustments are necessary for stock splits,

since market capitalization does not change and the share number and share price are adjusted prior to the opening of trading on the split’s ex-date)

1.3.3.2 Divisor adjustment formula

Whenever a corporation implements an action that affects its stocks (such as dividend payment, stock split or rights offering etc.), the divisor needs to be adjusted upwards, downwards or remain the same Assuming stockholders receive ―B‖ new stocks for every ―A‖ stocks they own in the following corporate actions:

Table 1.1: Divisor adjustment formula table

Adjusted case by case Adjusted case by case

8 Cash dividend and

stock dividend

Pt+1=(Pt-cash dividend)*A/(A+B)

Qt+1= Qt*(A+B)/A

9 Cash dividend and

rights offering

Pt+1=[(Pt-cash dividend)*A+subscription price *B]/(A+B)

Qt+1=Qt*(A+B)/A

10 Stock dividend and

rights offering

Pt+1=(Pt*A+subscription price*C)/(A+B+C)

Qt+1=Qt*(A+B+C)/A

No Corporate action Adjusted price (P t+1 ) Adjusted outstanding

shares (Q t+1 )

11 Cash dividend and

stock dividend and

rights offering

Pt+1=(Pt-cash dividend)*A+subscription price*C)/(A+B+C)

Qt+1=Qt*(A+B+C)/A

Source: FPT Securities Companies, Analysis Department, 2008

1.3.3.3 Timing of divisor adjustments

1 For rights offering and stock dividend

 On the ex-right date, the share price, number of outstanding shares and divisor will be adjusted based on information about rights exercise, share price and outstanding shares of the last trading session The number of outstanding shares is adjusted upwards by the provisional formula-based number of additional shares

 On the effective listing date of additional shares, the number of outstanding shares is adjusted again (if there is any difference between the provisional number of additional shares and the actual number of additional shares issued) 1 according to data provided by HOSE and HASTC

2 For the purchase and sale of treasury stocks

The adjustment date is the date when the corporation announces the purchase or sale of treasury stocks is completed in accordance with the registered trading time In case the registered volume of treasury stocks to be bought/sold is not fully bought/sold on the last day of registered trading time and the corporation registers to buy/sell the rest, we continue to adjust the

1

In reality, the effective listing date of additional shares occurs after the ex-right date

number of outstanding shares on the last day of this supplementary trading time pursuant to the corporation’s announcement

1.3.4 Step 4: Index calculation

Equation 1.6: Index calculation formula

In which

It: Index value of day t

Dt: divisor of the day t A divisor is used to re-base the index to start the index at the base value

MVt: the total market value of the day t

The value of Qt depends on the weighing scheme of each weighting method See Step 1: Calculation methods on page 11 above

Chapter 2: ANALYSIS OF SECTOR INDICES

2.1 Analysis of international sector indices

2.1.1 S&P select industry indices

2.1.1.1 Index Description

The S&P Select Industry Indices are designed to measure the performance of narrow Global Industry Classification Standard (GICS) sub-industries or groups of sub-industries S&P industry indices have base value

of 1000 on December 15, 2000

2.1.1.2 Sector classification system

The GICS structure consists of 10 sectors, 24 industry groups, 67 industries and 147 sub- industries Companies are classified primarily based

on revenues; however, earnings and market perception are also considered in classification analysis The GICS sub-industry level offers the most granular level of industry definition Therefore, the S&P Select Industry Indices offer the purest representation of a particular industry

2.1.1.3 Index membership

Membership is based on a company’s GICS classification, as well as liquidity and market cap requirements To be eligible for an S&P Select Industry Index, companies must rank in the top 90% of their relevant GICS sub-industry by float- adjusted market capitalization Those stocks at the top, whose cumulative market capitalization is less than or equal to 90% of the total float-adjusted market capitalization of the sub-industry, are deemed to qualify

Membership requirements include:

 Market Capitalization: Stocks with a float-adjusted market capitalization

above US$ 500 million and meet the liquidity threshold are included in order of their float- adjusted market capitalization until the stock count reaches 21 The float-adjusted market capitalization of these stocks must combine to be at least 90% of the total sub-industry market capitalization

If the index still does not have enough stocks that meet the criteria for inclusion, the minimum market capitalization requirements may be relaxed until the other requirements have been satisfied

 Liquidity Constituents must have a liquidity ratio defined by dollar

value traded over the previous 12 months divided by average market capitalization over the previous 12 months - greater than 30% The length of time to evaluate liquidity is reduced to available trading period for IPOs or spin-offs that do not have 12 months of trading history

 Domicile U.S companies only

Index rebalancing occurs after the closing on the third Friday of the quarter ending month The reference date for additions and deletions is after the closing of the last trading date of the previous month

 Additions No companies are added between rebalancing In the case

of mergers involving at least one index constituent, the merged company will remain in the index if it meets all of the eligibility requirements The merged company will be added to the index at the weight of the pre-merger index constituent If both companies involved

in a merger are index constituents, the merged company will be added

at the weight of the company deemed the acquirer in the transaction

 Deletions A company is deleted from a Select Industry index if the

S&P Total Market Index drops the constituent If a constituent deletion causes the number of companies in the relevant index to fall below 21,

no addition will be made to the index until the next rebalancing At that time, the entire index will be rebalanced based on all eligibility criteria, including minimum number of companies

2.1.1.4 Index calculation

The index series is equal-weighted and calculated by the divisor

methodology used in all Standard & Poor’s equity indices

The initial divisor is set to have a base index value of 1000 on December 15, 2000 The index value is simply the index market value divided

by the index divisor:

In which N is the number of stocks in the index

At the beginning of each quarterly rebalancing, Index Shares are set so that each constituent has equal weight

In which K is an arbitrary or nominal value used to ensure each company’s ―shares‖ number is derived to establish equal weighting in the index

In order to maintain index series continuity, it is also necessary to adjust the divisor at each rebalancing

(Index Value)before rebalance = (Index Value)after rebalance

as of December 31, 1991

2.1.2.2 Sector classification system

Industry indices are constructed by categorizing the component stocks

of the Dow Jones U.S Index into the 10 Industries, 19 Super sectors, 41 Sectors and 114 Subsectors of the Industry Classification Benchmark (ICB) A separate index is maintained for each group at each of the four levels Companies are classified into Subsectors, the most specific level of classification, based on their primary source of revenue The Subsectors are

rolled up into Sectors, which in turn are rolled up into Super sectors and finally into Industries, the broadest level of classification

2.1.2.3 Index membership

The index universe is defined as all stocks traded on the major U.S stock exchanges, minus any non-common issues and illiquid stocks For each industry index, the top-ranked stocks in terms of size and liquidity are chosen from the corresponding selection list as components:

1 The index universe is sorted by free-float market capitalization

2 Stocks in the top 95% of the index universe by free-float market capitalization are selected as components of the Dow Jones U.S Index, skipping stocks that fall within the bottom 1% of the universe by free-float market capitalization and within the bottom 01% of the universe by turnover

2.1.3.2 Sector classification system

NASDAQ Financial-100 Index employs the Industry Classification Benchmark (ICB) system to classify its members as belonging to financial sector

2.1.3.3 Index membership

Index eligibility is limited to specific security types only The security types eligible for the Index include foreign or domestic common stocks, ordinary shares, ADRs, shares of beneficial interest or limited partnership interests, and tracking stocks Security types not included in the Index are closed-end funds, convertible debentures, exchange traded funds, preferred stocks, rights, warrants, units and other derivative securities

To be eligible for inclusion in the Index, a security must be listed on The NASDAQ Stock Market and meet the following criteria:

 The security’s U.S listing must be exclusively on the NASDAQ Global Select Market or the NASDAQ Global Market (unless the security was dually listed on another U.S market prior to January 1, 2004 and has continuously maintained such listing);

 The issuer of the security must be classified according to the Industry Classification Benchmark (ICB) as Financials;

 The security may not be issued by an issuer currently in bankruptcy proceedings;

 If the issuer of the security is organized under the laws of a jurisdiction outside the U.S., then such security must have listed options on a recognized options market in the U.S or be eligible for listed options trading on a recognized options market in the U.S.;

 Only one class of security per issue is allowed;

 The issuer of the security may not have entered into a definitive agreement or other arrangement which would likely result in the security no longer being Index eligible;

 The issuer of the security may not have annual financial statements with an audit opinion that is currently withdrawn;

 The issuer of the security must have ―seasoned‖ on NASDAQ or another recognized market (generally, a company is considered to be seasoned by NASDAQ if it has been

 Listed on a market for at least two years; in the case of spin-offs, the operating history of the spin-off will be considered); and

 If a security would otherwise qualify to be in the top 25% of the issues included in the Index by market capitalization for the six prior consecutive month-ends, then a one year ―seasoning‖ criteria would apply

2.1.3.4 Index calculation

The NASDAQ Financial-100 Index is a market capitalization-weighted index The value of the Index equals the aggregate value of the Index share weights, also known as the Index Shares, of each of the Index Securities multiplied by each such security’s last sale price, and divided by the Divisor

of the Index The Divisor serves the purpose of scaling such aggregate value

to a lower order of magnitude which is more desirable for Index reporting purposes If trading in an Index Security is halted while the market is open, the last traded price for that security is used for all index computations until

trading resumes If trading is halted before the market is open, the previous day’s last sale price is used The formula for Index value is as follows:

Aggregate Adjusted Market Value/Divisor

The Index is ordinarily calculated without regard to cash dividends on Index securities The Index is calculated during the trading day and is disseminated every 15 seconds from 09:30:15 to 17:16:00 ET through the NASDAQ Index Dissemination Services (NIDSSM) The closing value of the Index may change up until 17:15:00 ET due to corrections to the last sale price of the Index Securities

2.1.4 MorningStar sector Indices

2.1.4.2 Sector classification system

The Morningstar Sector Structure is a three-tiered classification system that groups companies engaged in similar lines of business by varying levels

of granularity

The Morningstar sector index family consists of a comprehensive set of indices that collectively target 97% coverage of the U.S equity markets The Morningstar sector index family consists of:

 A broad market index: Morningstar US Market Index

 Three Morningstar Super Sector Indices

 12 Morningstar Industry Sector Indices

Source: MorningStar, http://www.morningstar.com/

Figure 2.1: Summary of Morningstar sector index family

 Securities that have more than 10 non-trading days in the prior quarter are excluded

 The following security types do not qualify:

 American Depository Receipts and American Depository Shares

 Fixed-dividend shares

 Convertible notes, warrants, and rights

 Tracking stocks

 Limited partnerships and holding companies

 A security must be among the top 75% of the companies in the investable universe based on its liquidity score A security’s liquidity score is the average of its ranks on each of the following measures:

 The average monthly trading volume in $US during the six calendar months immediately prior to reconstitution or, in the case of corporate entities younger than six months, since the security was first issued (partial month periods are prorated by number of trading days in the month)

 The lowest 2 months’ total trading volume during the six calendar months immediately prior to reconstitution (the months need not be sequential)

2.1.4.4 Index calculation

The value (price) and total return of an index is calculated using the following formula

The above formulas can be simplified as: Index (t) = M(t)/D(t)

Where:

D(t) = divisor at time (t)=B(t)/Base Index Value

Pi(0)= closing price of stock i at the base date

Qi(0)= number of shares of company i at the base

Pi(t) = price of stock i at time (t)

Qi(t) = number of shares of company i at time (t)

C(t) = adjustment factor for the base date market capitalization

M(t) = market capitalization of the index at time (t)

B(t) = adjusted base date market capitalization of the index at time (t)

2.1.5 NYSE Sector Indices

2.1.5.1 Index description and sector classification system

The NYSE Sector Indices are subsets of the NYSE Composite Index and consist of three separate indices representing the following market sectors: Energy, Financial, and Health Care Component in each of the three NYSE Sector Indices include NYSE-listed common stocks that are classified according to the Dow Jones Global Classification System These indices are introduced to give investors and issuers a more defined snapshot of key segments of the NYSE marketplace The three new sector indices supersede the old NYSE sub-indices – Industrial, Financial, Transportation, and Utilities indices

Each of the three NYSE Sector Indices has a base date of December 31,

2002 The closing market value on this date was given an index value of 5,000 (December 31, 2002=5,000)

2.1.5.2 Index membership

A company must have its shares listed on the New York Stock Exchange in order to be eligible for inclusion in any of the NYSE Sector Indices Only common stocks, ADRs, REITs and tracking stocks listed on the NYSE are eligible for inclusion; multiple classes of shares can also be included in the Composite Preferred stocks, closed-end funds, exchange-traded funds, trust units, shares of beneficial interest, limited partnerships, and derivative securities such as warrants and rights are not eligible

1 Additions

Additions to the NYSE Sector Indices can be a result of new NYSE listings, IPOs, spin-offs and takeovers New listings and IPOs are added to an NYSE Sector Index at the close of trading on their first day of trading on the NYSE If an index constituent spins off a portion of its business to form one

or more new companies, all new companies will be immediately included in the Sector Index If an index constituent merges with another company, the newly formed company becomes a member of the Sector Index after the close

of trading on the effective date of the merger provided it meets the membership criteria

2 Deletions

Deletions from the NYSE Sector Indices can be a result of NYSE delisting, takeovers, and bankruptcies A stock delisted from the NYSE is deleted from a NYSE Sector Index on the day it stops trading on the Exchange If an index component is taken over by another component company, the former will be removed from the index immediately upon