What is a Stock Index?

A stock index is an imaginary portfolio of stocks that are intended to represent the performance of a certain sector of the stock market. The value of the index assumes that one holds a portfolio of the stocks in the index, in the same proportions indicated by the index itself.

The Dow Jones Industrials Average, DJIA, is composed of 30 of America’s flagship corporations. These are all stable companies with huge operations and world wide sales. Their price performance is often used to gauge the health of the U. S. economy, or at least, the stock market’s view of the economy. The Russell 2000 and the S&P MidCap 400 are at the other end of the spectrum and represent smaller companies with more volatile stock prices.

Indexed accounts use a variety of stock indexes in their crediting strategies and some make use of bond indexes, as well. Indexes, of course, mirror the characteristics of the stocks they represent. Under some market condition all the stock indexes may react in much the same manner. However, there are often significant differences, even extreme differences, in how each index will react to any given set of economic events. It is important for the indexed-account holder to understand what type of stocks their index represents and the volatility it will exhibit under various market conditions.

Capitalization

One important difference between various indexes is how they are constructed. Most indexes are capitalization weighted. That means the big companies count more than the little companies. Compare for example two indexes we have constructed from the stock prices of Company A and Company B, call them ABC and ABE indexes. ABC is capital weighted. The amount of influence that each company has on the index is determined by the total market value of its shares. On the other had, the ABE index, is made up of equal amounts of each company.

The two indexes are quite different even though they are constructed of the same stocks. A $3 price rise in company A will sent the ABC index up over 7%, but a 30% price drop in Company B, will barely budge the ABC. In contrast, both prices changes will move the ABE an amount that reflects the amount of the price change of both stocks.

Volatility

The volatility is the speed and the range of the price changes of an index. Some, indexes like the Dow Jones Industrial Average, DJIA, are generally a little more stable that the overall market. This is because the companies are well established, pay a substantial base dividend and have world wide profits centers that are at least a little insulated from the economy of any one single country.

The S&P 500 Stock index, on the other had, is so large and encompassing that it has volatility that pretty much matches the U.S. stock market as a whole. Other indexes like the NASDQ100 and the Russell 2000 cover a number of more speculative stocks, whose fortunes rise quicker and fall faster than their blue chip cousins.

Volatility is extremely important in an indexed account, because volatility is what produces index based bonus interest. In a direct investment, the more volatile a stock, the higher the investment risk. However, in an indexed account with an annual reset, high volatility can generate significant bonus interest when a stock index cycles through its bear and bull market extremes.

Unfortunately, high volatility can be expensive to hedge. The price of options and other sophisticated market hedges are based, to a large extent, on the volatility of an index. Therefore, volatility, as it pertains to an indexed account, can be a double edge sword.

Dividends

Which indexes represent stocks that dividends is important for two reasons. One, the presence of a substantial dividend can add price stability to a stock. In a falling market, the price of the stock may approach a level where the dividend is near the level of interest rates. At this point the stock prices will begin to be more responsive to bond prices, than those of other stocks. When the price is high and the dividend return is small, the stock dividend is of much less importatnce in determining the price of the stock.

Second, when you purchase an indexed account, the actual stock is never purchased. The insurance companies purchases market hedging devices, but never the individual stock. Therefore, the dividend plays no role (except for its effect on prices). Holders of an indexed account do not receive dividends and neither does the insurance carrier.

Individuals who choose an indexed account, over a direct investment in the stocks of an index, are forgoing dividends, in exchange for the protection of their principal. The indexed account may earn them a substantial portion of the market gain, but there is no mechanism in an indexed account to collect any portion of the dividends that would be paid on the stocks the make up the index.

If your indexed account uses a stock index with a relatively small dividend component, this is not a consideration. However, if your index is the Dow, the dividend may represent a substantial difference between the return on the indexed account and a direct investment in Dow stocks. An indexed account offers absolute safety of principal and stock market linked returns. To get the full potential benefit of the stock market, you have to take the full potential risk of the stock market.

Since stock prices fluctuate broadly and dividend yield is expressed as a pecentage of price, the dividend yield of a stock index can be expected be less than stable. The table below indicates the value of the dividend for three common stock indexes as of December 23, 2007:

* As of Dec 23, 2007 only 27 of the stocks making up the NASDAQ100 paid dividends and 73 made no stock distributions.

Commonly Indexed Stock Indexes

S&P 500 Stock Index is the index most often found as the basis for an indexed account. It is made up of the 500 largest American companies and represents about 80% of the U.S. equities market and many consider it an ideal proxy for the total stock market.

ExxonMobil is the largest company in the S&P500 and makes up 3.88% of the index. Microsoft is #3 at 1.94% of the index and the Bank of American, at 1.6%, is #6. Best Buy and CBS are near the middle of the pack at 0.14% each. Some of the smallest stocks include OfficeMax, Circuit City and Wendy’s at 0.02% or less. Wide prices swings in the lower weighted stocks will have little impact on the index, but even moderate price volatility in the major capitalized stocks can move the entire S&P500 index.

S&P 500 Stock Index is capitalization weighted, but there is a separate index, notated by S&P EWI, that is equal weighted and rebalanced annually. Each stock represents 0.2% of the total and this separate index may react very differently than its more traditional counterpart. Be sure you know which S&P 500 is being indexed. The smaller stocks will have a much larger impact on the EWI, making it much more volatile.

S&P MidCap 400 is sometimes offered as an indexing option. This index is capitalization weighted and represents the middle range of the market and about 7% of U.S. equities by market value. These are the 400 stocks just below the S&P 500. There is no overlap between the two indexes. Historically the S&P 400 has very different volatility than the S&P 500. For other S&P Indexes are addition information please see http://www2.standardandpoors.com

Dow Jones Industrial Average (DJIA) is perhaps the second most indexed stock index. It consists of 30 industrial stocks (no transportation or utilities allowed). The most highly weighted is IBM at 6.98%, ExxonMobile and Boeing are next at 5.53% and 5.39%. The lowest rated include Pfizer at 1.47% and Intel at 1.37%.

The DJIA is price weighted to maintain the historical relationship between its member companies. The DJIA was originally designed to be the blue chip bell weather, but over the years, some of its component stocks have ceased to be industry leaders. Other stocks, that were not included in the original Dow have risen to prominence in their stead. Additionally, the role of various industries in our economy has changed radically since the initial formation of the Dow.

The keepers of the Dow, therefore, began to periodically change the make-up of the Dow, so as to always maintain its blue chip flavor. For additional information see http://www.djindexes.com/

NASDAQ100 is made up of the largest 100 stocks traded on the National Association of Securities Dealer’s Automated Quotations system This index is highly weighted in the technology sector and includes stocks such as Microsoft, Oracle, Yahoo, Logitech, Amazon, Apple, NVIDIA, Intel, Adobe Systems, Dell, eBay, Autodesk, Cisco, Sun Microsystems and others. Non Technology stocks include: Bed Bath & Beyond, Staples and Costco.

NASDAQ100 is partially weighted. The stock price and per share dividends are multiplied by the NASDAQ weighting factor and then scaled to millions. For additional information see http://www.nasdaq.com/

The Russell 2000 centers on the smallest 2000 companies in the top 30000 U.S. companies. It is capital weighted and its largest company is CF Holdings at around $2.5 billion in market value. The median (middle) is around $705.4 million and Gander Mountain Company brings up the rear at $261.8 million in market value. By contrast the largest company in the Russell 1000 is ExxonMobil at $485.6 billion.

Russell 2000 is a market value weighted indexes. Only those shares available for public trading are used to compute market value. Indexes are rebalanced annually to keep companies from outgrowing their peers in the index. A small cap that becomes a large cap is moved to another index.

Russell indexes are a group of stock indexes that are weighted and sorted by capital size and rebalanced annually to insure consistency. Other Russell indexes include Russell 2500 that includes the Russell 2000 and the lower half of the Russell 1000. There is also the Russell MidCap, the SmallCap and the MicroCap at median capitalization of $4.7 billion, $958.1, and $260 million respectively. Information on the Russell indexes can be found at http://www.russell.com

Please note that the same stocks can be found in several different stock indexes. How much one index reacts in relationship to another index is beyond the scope of this discussion and requires a considerable amount of analysis. If you are considering an indexed account, ask you agent which index is appropriate to your situation.

Nothing in this presentation is intended to recommend one stock index over another for use in an indexed account. Our sole purpose is to aquaint the reader with the differences between the various indexes and direct them to sources of additional information on the structure and characteristics of stock market indexes.

Capitalization and index make up provided herein are as Dec 31, 2007.