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7/28/2019 Benchmark Construction
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Benchmark Construction
October 2009
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Benchmark Construction 1
Contents
I. Dow Jones Industrial Average
II. S&P 500
III. Russell Indexes
a. Not All Market Caps Are Created Equal
b. Index Profiles by Market Capitalization
c. Differentiating Between Value and Growth
IV. MSCI Indexes
a. Defining Value and Growth StylesV. Appendix
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I. Dow Jones Industrial Average
The Dow Jones Industrial Average (DJIA) is frequently cited as a proxy for the U.S. equity market.
Formed in 1896 as a 12-stock index, its lengthy history helps to establish the index as one of the best-
known market indicators in the world. Its initial purpose was simply to help investors better understand
fractional price changes and the overall trend of the U.S. equity market. Charles Dow, a founder of theindex, related this to placing sticks in the beach to determine, wave after wave, whether the tide was
coming in or going out. If the peaks and troughs moved higher, it was considered a bull market; if they
dipped lower, it was considered a bear market.
Reflecting the economy at the time, the original index focused on agricultural products and basic
materials such as coal, iron, lead, leather, and rubber. The index expanded to include 20 stocks in 1916,
then to its current level of 30 stocks in 1928. Today, the index looks completely different from its original
structure: technology companies, financial service providers, manufacturers, and retailers now dominate
the Dow Jones 30. The index includes stocks that trade on both the New York Stock Exchange and the
Nasdaq Stock Market.
Unlike many other market indexes, the DJIA components are selected at the discretion of the editors of
The Wall Street Journal. The only requirement for inclusion is that the company should be an
established U.S. firm considered to be a leader in its industry. Editors look for a history of growth and a
wide interest among investors. Transportation and utility firms are excluded, as Dow Jones maintains
separate averages for those types of stocks. Changes to the composite are rare and typically occur only
following corporate acquisitions or other dramatic shifts in a components core business. If one stock is
changed, the remaining stocks in the index are reviewed for continued appropriateness in the index.
The Dow Jones averages are unique in that they are price-weighted rather than market-capitalization
weighted indexes. In its infancy, the index value was calculated by adding the price of each stock and
dividing by the total number of stocks in the index. Over the years, however, adjustments have beennecessary to account for various corporate actions, such as stock splits and stock dividends. The formula
for calculating a divisor change is as follows:
Dt+1 = Dt x Ca
t / Ct
Where:
Dt+1 Divisor to be effective on trading session t+1
Dt Divisor on trading session t
Cat Components adjusted closing prices for stock dividends, splits, spin-offs and other applicable
corporate actions on trading session t
Ct Components closing prices on trading session t
The divisor, which is adjusted on an as-needed basis, maintains the historical continuity of the index.
Adjustments are also made following component switches (a new stock is added to the index), spin-offs
and rights offerings, as well as special or unusually large dividend payments. Typically, changes to the
divisor move the number downward: following a two-for-one stock split by Merck & Co. in 1986, the
divisor fell below 1.0 for the first time; as of September 30, 2009, the divisor stands at 0.132319125.
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To better understand how this translates to the Dow Jones average, imagine a one point change in one of
the Dow components. As shown below, a one point change would lead to a more than seven point
change to the DJIA:
1 / 0.132319125 = 7.56
Of the 30 stocks currently in the Dow Jones Industrial Average, only General Electric was among theoriginal 12 industrial stocks. The stock moved in and out of the index several times before becoming a
seemingly permanent member of the index in 1907. The current DJIA stocks are shown below:
As of June 30, 2009
Stock Date Added Replaced
Alcoa June 1, 1959 National Steel
American Express August 30, 1982 Manville
AT&T1
November 1, 1999 Union Carbide
Bank of America February 19, 2008 Altria Group
Boeing March 12, 1987 Inco
Caterpillar May 6, 1991 Navistar International
Chevron February 19, 2008 Honeywell International
Cisco Systems June 8, 2009 Citigroup
Coca-Cola March 12, 1987 Owens-Illinois Glass
DuPont November 20, 1935 Borden
ExxonMobil October 1, 1928 Index expansion
General Electric November 7, 1907 Tennessee Coal & Iron
Home Depot November 1, 1999 Sears, Roebuck
Hewlett-Packard March 17, 1997 Texaco
IBM June 29, 1979 Chrysler
Intel November 1, 1999 Goodyear Tire & Rubber
JPMorganChase May 6, 1991 Primerica
Johnson & Johnson March 17, 1997 Bethlehem Steel
Kraft Foods September 22, 2008 AIG
McDonalds October 30, 1985 American Brands
Merck June 29, 1979 Esmark
Microsoft November 1, 1999 Chevron
3M August 9, 1976 Anaconda Copper
Pfizer April 8, 2004 Eastman Kodak
Procter & Gamble May 26, 1932 United Air Transport
Travelers June 8, 2009 General MotorsUnited Technologies March 14, 1939 Nash Kelvinator
Verizon Communications April 8, 2004 International Paper
Wal-Mart Stores March 17, 1997 Woolworth
Walt Disney May 6, 1991 USX
1 Name change from SBC Communications to AT&T Inc. following merger with AT&T on November 21, 2005
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II. S&P 500
Similar to those of the Dow Jones Industrial Average, components of Standard & Poors (S&P) 500 Index
are selected by a committee to be representative of various industries in the U.S. economy. The index
focuses on the large-cap segment of the market, covering 500 of the largest companies and roughly 75%
of the markets total capitalization. Following the DJIA, it is perhaps the most commonly cited equitymarket index in the world.
In addition to the S&P 500 (which includes stocks with a market value greater than $3.0 billion),
Standard & Poors also provides indexes that follow the mid- and small-cap segments of the market: the
S&P MidCap 400, roughly covering the next 400 stocks in terms of market weight, typically has an
unadjusted market capitalization of $750 million to $3.3 billion, while the S&P SmallCap 600 (covering the
next 600 smallest) has a capitalization range of $200 million to $1 billion. For each of these indexes, there
are a number of eligibility criteria that must be met for inclusion:
Liquiditythe ratio of annual dollar value traded to market capitalization should be 0.3 or greater.
DomicileU.S. companies should have the following characteristics:
Incorporated in the U.S.
Financial reporting via GAAP, in U.S. dollars, and not considered a foreign entity by the SEC
Corporate governance practice consistent with U.S. standards
Principal executive presence in the United States
U.S. portion of revenue, operations, fixed assets, and employees should be significant (though
not requiredto exceed than 50%)
Common stock should be listed on the NYSE, Amex, Nasdaq, or NYSE Arca (ADRs are not
acceptable).
Generally considered a U.S. company by analysts and investors
Public Floatat least 50% of the stock.
Financial Viabilitygenerally speaking, four consecutive quarters of positive reported earnings.
IPOsseasoned for a 6- to 12-month period before considered for inclusion.
Company typemust be an operating company. Closed-end funds, holding companies, partnerships,
investment vehicles, and royalty trusts are not eligible. Real estate investment trusts (REITs) and
business development companies (BDCs) are eligible for inclusion.
Unlike the DJIA, which is a price-weighted index, the S&P 500 is market-capitalization weighted. Its value
is calculated as the quotient of the total float-adjusted market capitalization (shares used in the calculation
reflect those available to investors, rather than all outstanding shares) of the indexs constituents and its
divisor. Much like the DJIA, the divisor is adjusted to reflect changes to the constituents share capital
after the base date, adjusting for things such as stock splits, stock dividends, etc.
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III. Russell Indexes
The Frank Russell Company has developed a number of equity indexes, differentiated by size (large-,
mid-, small-, and micro-cap) and style (value and growth) that are widely used as equity performance
benchmarks. The basis for all of the Russell indexes is the Russell 3000E (where E stands for
extended), comprising the 4,000 largest stocks incorporated in the U.S. and its territories, ranked bytotal market capitalization.
Companies grow larger or smaller over time and style characteristics sometimes shift, therefore, Russell
believes reconstitution is an important step to ensure their benchmarks accurately reflect the U.S. equity
market. Membership and stock weights in the Russell 3000E, and the sub-indexes derived from it, are
reevaluated each year as of May 31. The reconstitution itself has occurred on the last Friday in June
since 2004 (rather than the last day of the month), this year (2009) taking place on June 26. Also, since
2004, eligible IPOs have been added to their appropriate indexes on a quarterly basis, as Russell
believes it is important to reflect market additions between each annual reconstitution. The only other
mid-year additions are: corporate spin-offs, with the new company added to the parent companys index.
However, companies that have been removed from Russells indexes due to mergers, acquisitions, orsimilar corporate restructurings during the year are not replaced until the next reconstitution date.
All U.S-incorporated companies are eligible for inclusion in the Russell Indexes. Beginning in 2007,
Russell also began reviewing companies incorporated in Anguilla, Antigua, Bahamas, Barbados, Belize,
Bermuda, British Virgin Islands, Cayman Islands, Channel Islands, Cook Islands, Faroe Islands, Gibraltar,
Isle of Man, Liberia, Marshall Islands, Netherlands Antilles, Panama, and Turks and Caicos. Companies
incorporated there are considered to be Benefit-Driven Incorporation (BDI) companies because
companies generally incorporate in these countries or regions for operational, tax, political, or other
financial market benefits. In order for a BDI to meet eligibility requirements for inclusion in the Russell
indexes, it must meet ONE of the following criteria:
Company headquartered in the U.S. Company headquartered in a BDI-designated country or region, with primary exchange for local
shares occurring in the U.S. (Primary exchange is determined by the average daily dollar traded
volume. Headquarters and primary exchange location are evaluated once each year.)
The following are excluded from the Russell indexes:
Bulletin board, pink sheet, or over-the-counter (OTC) securities
Stocks trading below $1.00 per share on the last trading day in May
Minimum market capitalization below $30 million
Large-capitalization firms with 1% or less float
Small-capitalization firms with 5% or less float
Participating preferred, convertible preferred, and preferred stock
Redeemable shares
Warrants and rights
Trust receipts
Royalty trusts, limited liability companies, closed-end investment companies, blank-check
companies, special-purpose acquisition companies, and limited partnerships
Berkshire Hathaway, as a special exception
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Among recent changes to eligibility: The exclusion of blank-check companies and special purpose
acquisition companies became effective the first quarter of 2008. Also of note, while closed-end
investment companies are not eligible for inclusion in the Russell indexes, business development
companies (BDCs) are eligible.
Russell had made a number of changes in recent years designed to lower turnover and avoid front-running changes to the index. This was the third year Russell used a banding methodology as part of its
annual reconstitution. Simply put, this provides a cushion to borderline stocks from being automatically
moved up or down between the larger- and smaller-cap indexes. While new members to the index are
assigned a size category along strict capitalization guidelines, more leeway is provided to existing index
members. Currently, Russell places a cumulative 5% market-cap range around these breakpoints in most
indexes such that a stock can fall within 2.5 percentage points of the break without moving to a new
capitalization index. The only differences:
The micro-cap index is banded at 1%, or 0.5 points
There is no percentile banding around the bottom of the Russell 3000 or Russell 3000E Index
Not All Market Caps Are Created Equal
After membership is determined, shares are adjusted to include only those that are publicly available
often referred to as the free float. Stocks are weighted within the index by their float-adjusted market
capitalization. To determine the number of available shares, Russell subtracts large private or corporate
shares if they exceed 10% of shares outstanding, ESOP and LESOP shares that comprise 10% or more
of outstanding shares, and corporate cross-owned shares from a firms total shares outstanding. Unlisted
share classes, IPO lock-ups, and government holdings are also included in capitalization adjustment.
In calculating market capitalization, Russell multiplies the May 31 closing price of a stock by the free-float
share adjustment. Such adjustments can have a significant impact on a firms total market capitalization;Wal-Mart is a prime example: the Walton family, heirs to the Wal-Mart fortune, controls roughly 40% of
the big-box retailer. Russell excludes these shares from their calculations, forgoing more than 1.5 billion
shares and over $80 billion in market capitalization.
Google and Oracle are other notable examples, each with approximately 25% of its shares excluded in
Russell calculations.
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Index Profiles by Market Capitalization
Within the Russell 3000E, the market capitalization segments are broken down as follows:
IndexCompanies Included
(by market-cap rank)
Russell 3000E Index 1 4,000
Russell 3000 Index 1 3,000
Russell Top 200
Index 1 200
Russell Midcap
Index 201 1,000
Russell 1000
Index 1 1,000
Russell 2000
Index 1,001 3,000
Russell 2500TM
Index 501 3,000
Russell Microcap
Index 2,001 4,000
Differentiating Between Value and Growth
Russell classifies stocks as value or growth based on their relative book-to-price ratio and their
Institutional Brokers Estimate System (I/B/E/S) forecasted long-term growth rate.
The process is applied separately to the Russell 1000, Russell 2000, and the smallest 1000 stocks of the
Russell Microcap indexes to prevent distortion of their relative valuations.
A composite value score is generated for each stock, and a probability algorithm is applied to assign
growth and value weights. Stocks with lower composite scores are considered to be growth, while high
scores indicate value. Scores that fall in the middle are considered to have both value and growthcharacteristics and are weighted proportionately in the growth and value indexes. Stocks are fully
represented by the combination of their growth and value weight.
Generally speaking, 70% of the available market capitalization is classified as all-growth or all-value, with
the remaining 30% deemed a combination of value and growth. To avoid the existence of numerous small
weightings and to simplify passive management, a style weighting that exceeds 95% will be rounded up
to 100%.
Special considerations in determining style:
A companys reported book value is adjusted to reflect the Financial Accounting Standards
Boards rules FAS 106 (post-retirement benefits) and FAS 109 (income tax) write-offs, by addingback the unamortized portion of these charges. In 2007, Russell also made an adjustment to
book value for FASB 158 (pensions and other post-retirement plans).
If a stock has missing or negative values for book-to-price ratio or missing I/B/E/S growth rates,
the mean value score of the companys industry group, from the appropriate base index, is used.
Industry groups must have a minimum of five members or the substitution reverts to the sector.
Each missing variable is substituted with the sector or industry group independently.
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IV. MSCI Indexes
Similar to the Russell indexes, the Morgan Stanley Capital International (MSCI) indexes include
securities of U.S. incorporated firms listed on the NYSE, NYSE Arca, AMEX, and Nasdaq with the
following exceptions:
Stocks trading below $1.00 or above $5,000 Stocks that fall in the bottom 0.5% based on annualized traded value ratio
Free float-adjusted market capitalization below 10% of total capitalization (unless it represents
five basis points of the current Investable Market Index)
Investment trusts, other than REITs
Mutual Funds
Equity derivatives
Limited partnerships, limited liability companies and business trusts that are structured to be
taxed as limited partnerships
Royalty trusts
Additionally, small-cap stocks must trade for a minimum of three months before they can be consideredfor inclusion as this provides a sufficient period to assess their liquidity. Further, some non-U.S.
companies may be included for consideration based on analysis of factors such as the companys main
equity trading markets, shareholder base, and geographical distribution of operations (much like Russells
Benefits-Driven Incorporation).
MSCI views the U.S. equity market as having three capitalization segments: The investable market, the
micro-cap segment, and the lower micro-cap segment. The investable market consists of 2,500 names
ranked by total market capitalization, representing roughly 98% of the total capitalization of the U.S.
market. The micro-cap segment comprises those firms with a capitalization rank lower than the investable
universe but included in the top 99.5% of the market (essentially an additional 1.5% of the market-cap
weight of the entire U.S. market). Finally, the lower micro-cap segment is made up of the bottom 0.5% ofthe full market capitalization; this segment is notrepresented by an MSCI index.
The large-, mid-, and small-cap segments of the market are composed of holdings within the investable
market (the top 2,500 names). More specifically, the top 300 names is defined as the large-cap index, the
next 450 names make up the mid-cap index, and the bottom 1,750 companies are a part of the MSCI
Small-Cap Index. There is no specific target for the number of securities included in the micro-cap index;
all securities contained in the top 99.5% of U.S. equities that are not included in the Investable Universe
(the top 2,500 securities by market cap) are included in the MSCI Micro Cap Index as long as each
stocks full market capitalization exceeds $20 million.
Similar to Russells banding methodology, MSCI employs a buffer-zone around the market capitalizationcutoff levels for its indexes. Unlike Russell, however, this buffer zone is asymmetrical and significantly
wider. The zone consists of 100 companies on the upside, and another 150 on the downside. A mid-cap
stock, for example, would need a market-cap rank of 200 to move into the large-cap index, and on the
downside, a large-cap stock would need a rank of 451 before it moved into the mid-cap index. As one
moves further down the capitalization scale, the buffer zones become larger. Details are shown on the
following page:
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Large Cap Mid Cap Small Cap Micro Cap
Market Cap Segment Definition 1-300 301-750 751-2500
Upside Buffer Zone 201-300 551-750 1851-2500
Downside Buffer Zone 301-450 751-1100 2501-3000
MSCI reviews its indexes for capitalization appropriateness twice each year, in May and November. After
allowing for index migration as established by the above buffer zones, MSCI then fixes each index at its
set number such that the large-cap index always contains 300 stocks; the mid-cap index, 450; and 1750
stocks are in its small-cap index. If, for example, following those changes, fewer than 300 names were
included in the large-cap index, the largest names in the mid-cap index would migrate up until the number
of stocks in the large-cap index reached its specified level of 300. If a security falls in the buffer zone for
four consecutive semi-annual reviews, it will be reclassified to the appropriate index at that fourth review.
Defining Value and Growth Styles
MSCI uses a two-dimensional framework in order to classify securities as either growth or value style.
Characteristics pertinent to Value stocks include book/price, 12-month forward earnings per share (EPS),
and dividend yield. Growth measures include long-term forward EPS growth rate, short-term forward EPS
growth rate, current internal growth rate, long-term historical EPS growth trend, and long-term historical
sales per share growth trend. (As sales are not relevant to Financial-sector companies, this measure is
excluded from both the Banks and Diversified Financials industries.) After computing the eight variables
for each security, results are standardized within each market capitalization index and assigned a Z-score
that quantifies its distance (measured in standard deviations) from the mean.
As part of the standardization process, the data set is Winsorized to ensure that market averages are
less affected by outliers. A Winsorized mean involves trimming the extremities of a probability distribution
or sample and then replacing the trimmed values with the highest or lowest respective value remaining; in
other words, setting all values beyond a certain point to the value of that point. Here, all values within the
5th and 95th percentile ranges are assigned the single value closest to the 5th and 95th percentile,
respectively. This is repeated for each of the eight variables. Z-scores are then calculated using the free
float-adjusted market capitalization weighted market mean and the standard deviation of the relevant
variable within each market capitalization index. Z-scores for the three value measures are averaged, as
are the scores of the five growth variables (long-term forward EPS growth rate is given a double score as
MSCI views this as being most associated with growth). Stocks are then assigned growth and value
proportions based on their value and growth Z-scores as shown below:
ValueZ-Score GrowthZ-Score Style
+ - or 0 Value
- or 0 + Growth
+ + Both
- or 0 - or 0 Neither
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V. Appendix
Disclosures
OFI Institutional Asset Management ("OFI Institutional") is the marketing name used by each of the members of the OFI Institutional
Group that consists of institutional investment advisers affiliated with OppenheimerFunds, Inc. (OFI). The OFI Institutional Group
includes the following SEC registered investment advisers: OFI Institutional Asset Management, Inc. and Trinity Investment
Management Corporation. Professionals that provide portfolio management, analysis, trading, and other services for OFIInstitutional may be employed by members of the OFI Institutional Group, OFI, or an affiliate of OFI.
S&P 500 and S&P are trademarks of the McGraw-Hill Companies, Inc. The S&P 500 Index is a broad-based measure of domestic
stock performance that includes the reinvestment of dividends. The index is unmanaged and cannot be purchased directly by
investors. Index performance is shown for illustrative purposes only and does not predict or depict the performance of a particular
product.
The Russell 3000E Index, Russell 3000 Index, Russell Top 200 Index, Russell Midcap Index, Russell 1000 Index, Russell
2000 Index, Russell 2500 Index, and Russell Microcap Index are trademarks/service marks of the Frank Russell Company.
Past performance does not guarantee future results.
For Institutional Use Only. This material has been prepared by OFI Institutional Asset Management for institutional investors only. It
has not been filed with FINRA and may not be reproduced, shown, quoted to, or used with members of the public.
2009 OFI Institutional Asset Management. Allrights reserved.