Capped Index

Capped Index
See also
Overbought oversold indicator Vomma Stock market performance Bear flag Span margin Trading Book Interest rate differential Basket Option Implementation Shortfall

Capped index is one of the types of stock exchange indices, using the weighted capitalization method. It is used to describe the performance of a stock market or a specific part of it and to compare the return on investment (A. B. Mahayni, M. Muck 2017, p. 3-6) . A capped index is an indicator that tells investors how prices are changing, shows trends in the market over a certain period of time. It is a synthetic measure of changes in the price of securities covering all securities of a selected group or type (A. B. Mahayni, M. Muck 2017, p. 3-6). Groups of selected companies that have a significant impact on the behaviour of stock exchange investors. The stock market index is often compared to a thermometer, which measures the market temperature in a portable way. A stock index is an indicator showing the behaviour of a stock listed on the stock exchange. By observing the changes in the value of the index, it is possible to assess the level of return on the market and determine the direction of price movement without analysing the share prices of individual companies (A. B. Mahayni, M. Muck 2017, p. 3-6). In general, the capped index uses a weighted average of the share prices of companies. Each company in the index is represented in proportion to its total market capitalization. In other words, if the total market value of 500 companies in S&P 500 falls by 10%, the index value will also fall by 10%.Capped index includes companies from various sectors, including energy, industry, IT, healthcare, finance and consumer goods (A. B. Mahayni, M. Muck 2017, p. 3-6).

Development of the index over the years

Originally, the index defined the change in stock market prices that occurred in the short term because no long time frames were assumed (P. Varson,Zghidi L. S.2000, p.705 – 716). In the days when computers were not used, the index formed a narrow group of companies that had a significant impact on the market. Over time, a clear benchmark became necessary for investors to compare and measure long-term returns on their portfolios and the sectoral breakdown of selected groups of companies (P. Varson,Zghidi L. S.2000, p.705 – 716). In the 1960s, when the computer era and stock market development began, a multitude of new indices emerged to describe in detail the behaviour of selected markets or sectors. These indices did not cover the whole market, and the interest in small companies, their differences, was increasing, hence the introduction of small company-based indices in the 1970s. The next decade saw the development of futures contracts and options based on stock exchange indices, which became a favourable reference point for their settlement on the futures market (P. Varson,Zghidi L. S.2000, p.705 – 716). The following years saw the development of international indices, which include European, American and Asian stock exchange companies such as Morgan Stanley Capital International World Index, FT-Actuaries World Index, Dow Jones Stoxx 50. Stock indices are used by large corporations, financial institutions and banks to track and anticipate global trends and account for 70% of global stock market capitalization (P. Varson,Zghidi L. S.2000, p.705 – 716).

Characteristic

A Capped Index can show the full picture of the market and indicate the desired direction. It is an important tool in the hands of investors who analyze currency exchange rates and show market trends (P. Xu 2013, p16-20). It also helps technical analysts make the right decisions about the companies in their portfolios and anticipate future stock market trends and minimize risk. The measurement of Capped Index is based on a comparison of the changes occurring in all the companies. In technical analysis, they are used (P. Xu 2013, p.16-20):

• trends,
• moving averages
• ROC change rate indicator,
• MACD indicator,
• Relative Strength Index RSI.

Exchange index functions

The functions performed by the Capped Index are (H. Tang X. Xiaoqing,2017, p.85-103):

• convergent information about the situation on the market or its selected segments,
• an underlying for derivatives (options, futures and forwards),
• a reference point for assessing investment performance,
• A specialized tool that helps traders build their own stock market indicators, is a substitute for a market portfolio that is relevant to portfolio theory and capital market models (H. Tang X. Xiaoqing,2017, p.85-103).

Application of the capped index

The Capped Index is also used to identify the bull market or the bull market as a source of very important information, because on average 75% of the stock goes up during the bull market and 90% goes down during the bull market (H. Sarıtaş 2004, p. 121-123). Based on the rights traded on the stock exchange, the index becomes the underlying instrument for derivatives such as futures contracts or options. Such instruments are traded on the stock exchange and their current price depends on the future index value predicted by investors. In addition, futures contracts are an excellent way to hedge open positions on the spot market (H. Sarıtaş 2004, p. 121-123).

Characteristic

A good Capped Index should (H. Liu Y. Wang,2018, p.12-14):

• show the ongoing changes in share prices compared to the base period
• be based on shares of listed companies
• not depend on the value of shares, but on changes in those values
• take into account the shares of the selected company against the background of all shares on the stock exchange.
• To make it easy to assess investment performance, each index has a basic period in which the value of the index in a given period is taken as a round number, e.g. 100, each period's value is related to a basic period.

In a stock exchange index, there are three characteristics by which the indices differ from each other. It is (H. Liu Y. Wang,2018, p.12-14):

• the number of companies taken into account in the construction of the index,
• system of weights assigned to shares of particular companies
• the averaging method used to construct the index.

The number of companies usually includes in the index structure only a part of companies, those with the highest turnover, listed on a given market. An example are Dow-Jones indices, based on 30, 20, 15 and 65 companies respectively, European indices CAC-40 or DAX (H. Liu Y. Wang,2018, p.12-14). However, in order to represent the whole market in a more realistic way, one needs to construct indices from a large number of companies, as exemplified by Standard & Poor's 500, Value Line Averadge (about 1,700 companies), Nikkei 225. Rarely are indices for construction, which include all companies, an example are indices of the Warsaw Stock Exchange (WIG, WIRR) (H. Liu Y. Wang,2018, p.12-14).

Weighting of the index

The structure of the weights in the index is based on (H. Tang X. Xiaoqing,2017, p.85-103):

• the weighting of the market value, which is the quotient of the market value of the companies during the IP and the IP,
• weighting the share price of the company, where the weight is higher the higher the share price,
• acceptance of equal weights for companies, regardless of share price or market values, where the averaging is carried out by means of an arithmetic mean.

In the averaging method, the construction of the index is applied using the arithmetic and geometric mean, which in terms of price changes always remains smaller, grows slower and falls faster than the arithmetic mean (H. Tang X. Xiaoqing,2017, p.85-103). Choosing the right type of averaging is very important and important for the value of the index. An index that includes the same companies but uses different types of averaging can show different values. Therefore, before interpreting and determining the choice of index, the investor should know how the index is constructed (H. Tang X. Xiaoqing,2017, p.85-103).

Example of a capped index

Standard & Poor's 500 (S&P 500) is one of the most popular indices in the world. It has been calculated by the New York Stock Exchange since 1923. The index portfolio consists of shares of 500 selected companies. In addition to the index, Standard & Poor's Corporation also publishes indices (H. Tang X. Xiaoqing,2017, p.85-103):

• Changes in share prices of 400 industrial companies,
• Share price changes 20 public utility companies
• Share price changes 20 transport companies
• Changes in share prices of 40 financial institutions.

Advantages of Capped Index

Capped indexing is a popular investment strategy that seeks to provide investors with a more diversified portfolio and an improved risk/reward profile. Below are some of the advantages of using a capped index strategy:

• Diversification: A capped index strategy provides investors with a diversified portfolio by investing in a range of securities, including both stocks and bonds. This helps to spread risk across a wide range of investments.
• Lower Volatility: Capping the index reduces the risk of large losses, as stocks that have already reached their cap will not be included in the index. This helps to reduce the overall volatility and creates a smoother investment experience.
• Lower Expense Ratio: Capping an index reduces the overall expense ratio of the portfolio, as the portfolio is made up of fewer securities. This reduces the cost of the portfolio and increases the potential returns.
• Potential for Higher Returns: Capped indexes typically have higher returns than broad-based indexes, as the cap limits the amount of downside risk. This helps to boost the potential for higher returns in the long-term.

Limitations of Capped Index

One of the major limitations of using a capped index is that it limits the performance of an index and therefore the returns of investors who track the index. The following are some of the other limitations of using a capped index:

• It can lead to an underestimation of the true performance of a particular asset class, as only the top performing stocks will be included in the index.
• It can also lead to a distorted view of the market, as it doesn’t accurately reflect the performance of all stocks within the asset class.
• Capping an index also reduces the liquidity of the index, as the number of stocks that can be used to track the index is limited.
• Additionally, capping an index can lead to higher transaction costs, as the number of stocks included in the index is limited, reducing the amount of trading that can be done.
• Finally, capping an index can lead to increased volatility in the index, as the number of stocks that can be used to track the index is limited.

Other approaches related to Capped Index

Economics provides a variety of approaches to the concept of a Capped Index, a type of investment strategy that limits the risk of buying and selling a portfolio of securities by establishing a cap on the amount of return the investor can receive. These approaches include:

• Index Arbitrage: This strategy utilizes the price discrepancies between a related index and its component stocks to take advantage of short-term price movements.
• Index Swapping: This strategy involves taking advantage of price discrepancies between two related indices to buy and sell index securities.
• Covered Call Writing: This strategy involves selling call options on stocks that make up the index, thus capping the potential upside of the index investments.
• Indexed ETFs: Exchange-traded funds are a type of investment that tracks a specific index and provides investors with the opportunity to purchase a basket of stocks in one transaction.

In summary, Capped Index strategies provide investors with a way to limit the amount of risk associated with investing in a portfolio of stocks. These strategies include Index Arbitrage, Index Swapping, Covered Call Writing, and Indexed ETFs.

References

• Liu H. Wang Y., (2018), Index Investing and Price Discovery, SSNR Electronic Journal, China
• Mahayni A. B., (2017), The Benefit of Life Insurance Contracts with Capped Index Participation When Stock Prices are Subject to Jump Risk, Review of Derivatives Research, Germany
• Sarıtaş H., (2004), Indexing And Index Funds, Dokuz Elyul Universitesi IIBF Dergisi, Turkey
• Tang H.Xiaoqing X., (2017), A Review of Fixed-Income Indexing and Index Investing, Journal of Wealth Management, China
• Varson P., (2000), Standard and Poor's Depository Receipts and the performance of the S&P 500 Index futures market, Journal of Futures Markets, USA
• Xu P., (2013), Is the S&P 500 Index Tradable?, The Journal of Index Investing, Canada

Author: Rafal Maslyk