GB2393532A

GB2393532A - Fundamental stock market index and index fund or funds

Info

Publication number: GB2393532A
Application number: GB0222239A
Authority: GB
Inventors: Paul Wood
Original assignee: Individual
Current assignee: Individual
Priority date: 2002-09-25
Filing date: 2002-09-25
Publication date: 2004-03-31
Also published as: GB0222239D0

Abstract

A method for the construction of a new type of stock market index, and stock market index fund, or funds. The method is distinct from other types of stock market indices in that the index is constructed based upon the fundamental realities of the companies contained within the index rather than on the price, or market capitalization of the companies contained with the index. This fundamental data would include items such as the relative size of a collection of company's profits or assets or any fundamental accounting data contained within a standard U.K company annual report and accounts. A stock market index based upon the fundamentals of the companies within it, rather than on their price, or market capitalization, may provide a more stable and rational method for investing in a passive manner over the medium or longer term.

Description

Fundamental Stock Market Index and Index Fund or Funds.

Most commonly used stock market indices are constructed using a methodology that is based upon either the relative share prices calf a sample of companies (such as the Dow Jones Industrial Average) or the relative market capitalization of a sample of companies (such as the S&P 50() Index or the F;TSE 10() Index). The nature of the construction of both of these types of indices means that if the price or the market capitalization of one company rises relative to its peers it is accorded a larger weighting in the index. Alternatively. a company whose share price or market capitalization declines relative to the other companies in the index is accorded a smaller index weighting. This can create a situation where the index index funds or investors who desire their funds to closely track an index are compelled to have a higher weighting in companies whose share prices or market capitalizations have already risen and a lower weighting in companies that have seen a decline in their share price or market capitalization.

It is the inventors belief that these price or market capitalization based indices can contribute to a 'herding' behavior on the behalf ot' investors by et'fectively compelling any of the funds that attempt to follow these indices to have a larger weighting in shares as their price goes up and a lower weighting in shares that have declined in price. It is the inventor's beliet' that this creates unnecessary volatility which is not in the interests of most investors. It may also lead to investment returns that have had to absorb the phenomenon of having to repeatedly increase weightiness in shares after they have risen and reduce weightings in them after they have fallen.

A new series of fundamental stock market indices in which the index weightings arc determined by company fundamentals such as: the relative size of a company s profits or its pre exceptional profits or sales or return on investment or any fundamental accounting item or ratio. may help to address some of the issues raised above. An index that determines its weightings based on company fundamentals. rather than the share price or market capitalization' has a stabilizing element within it that can help to iron out the excess volatility that can be generated by indices that are constructed on the basis of price or market capitalization alone. Over the medium to longer term the inventor believes that such fundamentally based indices have the potential to outperform price or market capitalization-

based indices and do so with less volatility.

The invention described below describes a method for the creation of a new class of stock m arket indices and index funds. This new class of stock m arket indices bases its weihtings on the fundamentals of the companies that make up that index. One possible version of a fundamentally based stock market index would be an index that is based on the relative size of a sample of the companies pre exceptional profits. If the chosen sample of companies was determined to be one hundred and the fundamental criteria that the index manager decided to use was to be largest pre exceptional profits then the index would be contain the one hundred largest companies as defined by the size of their pre exceptional profits. As an example if the total pre exceptional profits of the largest one hundred companies as measured by their pre exceptional profits was 100 bn pounds in a defined time period (such as a quarter or year) and in the same time period the pre exceptional profits of theoretical company A were 2bn pounds then theoretical company A would be allocated a 2%

weighting in the fundamental index. If theoretical company B had pre exceptional profits ol 1.5bn pounds in the same time it would have a weighting h1 the index of l.S.,. Index weightings are managed based on how the fundamentals of the companies within, or outside, the chosen index sample change. As an example, the index manager could choose to rebalance the weightings either quarterly, as company pre exceptional profits change, or on an annual basis. It, for instance. by the time of the next rebalancing period the total pre exceptional profits of the largest one hundred companies, as measured by their pre exceptional profits, had grown to 120bn pounds, and theoretical company A now had pre exceptional profits of 1.2bn pounds its weighting in the index would be down to 1 from 2% in the previous period. The purpose of creating such fundamental indices is to give an investor the opportunity to follow, or invest, passively in an index which is anchored to the economic realities of the companies within it. The inventor believes that this new fundamental index construction technique will produce an index and related index fund products that will be more stable and more economically rational than those that exist at present. A fundamental stock market index can be created by using any of the fundamental data points regarding a company or a group of companies that can be found in a regular t].K company annual report and accounts. As one example, an index of companies could be created based on the relative size of the companies sales' assets' profits, cash flow or the shareholders etiuity. In addition, the fundamental index can also be created by using a ratio of any of the data concerning a company or group of companies that is contained in a standard U.K company report and accounts. One example of this could include the relative size of the return on assets of a selection of companies, their return on investment or their return on capital compared to their cost of capital. Once the index manager has decided which

fundamental criteria to use. and how many constitucats the manager decides that he or she wants to include in the index. the index can be created in the following way. If for example.

the index manager decides to construct a fundamental stock market index ot one hundred constituent members and if he or she decides to use pre exceptional profit as the chosen fundamental criteria the index can be made as follows. Firstly the index construction manager would have to perform a search to find which are the largest one hundred listed companies as defined by the size of their pre exceptional profits. Once the manager has determined this he or she is ready to construct the index. If the combined pre exceptional profits of the one hundred companies is 10)bn pounds and theoretical company A has pre exceptional profits of 2bn pounds then it would have an index weighting of Too. Companies would be accorded index weightings based on the relative size of their pre exceptional profits. Once the one hundred companies had been accorded their weightings it is then possible to begin to calculate the index performance going forward as the share prices of the different companies in the index changes from day to day. This can be achieved by assuming a starting value tor the index or index portfolio' and then calculating how each of the index constituents performs offing forward. The index manager can then choose to rebalance the index weightinos as the fundamental data points change over time. For instance if at the end ot the next company reporting season the combined pre exceptional profits of the one hundred largest companies had grown from l(N)bn pounds to 120bn pounds and the pre exceptional profits of theoretical company A had declined from 2bn pounds to 1.2bn pounds its weighting in the index would decline from 2% in the prior period to 1% hl the current period. Also it is distinctly possible that some of the original companies in the first one hundred may be eliminated from the index if their pre exceptional profits fall below a certain level while new companies that were not in the original sample could be included. The index

mane: er could choose to rebalance the weightings in the index either as individual companies report their pre exceptional profits on a quarterly basis or he or she could wait until the majority of companies had reported their pre exceptional profits and then adjust them all at once. Also the manager could choose to determine the weightings based on either the total nominal amount of pre exceptional profit each quarter or on a cumulative rolling basis.

Constructing a stock market index using fundamental company accounts data or a ratio. or manipulation of that data is intended to provide a series of genuine alternatives for investors who want to invest in a passive style while focusing on fundamentals that they believe are important. For instance an investor may always want to own an index of U.S. or foreign equities that are the largest five hundred companies as measured by sales or by profits or by growth in sales or by retune on investment or any fundamental company accounts data or ratio of that data.

Claims

(, CLAIMS

1. A method for the construction and management of a stock market index and stock m arket index funds containing a portfolio of stocks based on this index. The index is based on fundamental company data rather than on stock prices or market capitalization. This method comprises: The creation of a stock market index' end stock market index funds containing a portfolio of stocks where the constituent weightings are based upon any of the fundamental accounting data regarding these companies that can be found within a standard U.K company annual report and accounts.

2. The creation of a stock market index. and stock market index funds containing a portfolio of stocks where the constituent weightings are based upon any ratio' or any manipulation of the fundamental accounting data that is contained within a standard U.K company annual report and accounts.

T he management of a fundamentally based stock m arket index' end stock market index funds containing a portfolio of stocks based on this index' in which the relative weightings of the stocks within the fund are altered as the fundamental data concerning the companies in or outside the sample changes. This could be either when or after a company or companies report their accounting information.