A price return index reflects only changes in market prices, whereas a total return index reflects both price changes and income such as dividends or interest. If the securities generate no income during the period, there is no additional return to be reinvested in the total return version. As a result, both index versions will have identical values.

At inception, both versions of the index begin with the same base value. After inception, the total return index reflects reinvested dividends, while the price return index reflects only changes in market prices. Because the securities pay dividends, the total return version will diverge from the price return version once income is generated, even on rebalancing or reconstitution dates.

Security market indexes are created using defined selection criteria, weighting methods, and rebalancing rules, much like a systematically managed portfolio. Because index construction methodologies differ, they are not interchangeable across all asset classes. Additionally, index values are calculated using the actual market prices of the underlying securities.

The initial step in creating a security market index is defining the target market. Identifying the market, segment, or asset class determines the investment universe from which securities will be selected. Decisions regarding weighting methods and the number of constituents follow only after the target market has been clearly defined.

For a price return index, only price changes are included.

Delta return = (30 25) / 25 = 20%
Echo return = (38 40) / 40 = 5%
Foxtrot return = (35 35) / 35 = 0%

Because the index is equal-weighted, each security has a weight of one-third.

Index price return = (1/3) (20% 5% + 0%) = 5.0%.

Total return includes both price changes and dividends.

Atlas return = (24 20 + 2) / 20 = 6 / 20 = 30%
Beacon return = (33 30 + 0) / 30 = 3 / 30 = 10%
Crest return = (55 50 + 5) / 50 = 10 / 50 = 20%

Because the index is equal-weighted, each security has a weight of one-third.

Index total return = (30% + 10% + 20%) / 3 = 60% / 3 = 20%.

For a price-weighted index, the return is based on the percentage change in the sum of prices.

Beginning total price = 40 + 30 + 10 = 80
Ending total price = 44 + 20 + 12 = 76

Price return = (76 80) / 80
= 4 / 80
= 5%

Dividends are not included in a price return index calculation.

Identifying the target market specifies the universe of eligible securities available for inclusion in the index. Once the investment universe is defined, decisions regarding weighting methodology, number of constituents, and rebalancing procedures can be made. The target market itself does not automatically determine a fixed number of securities, nor is it limited to only broadly defined asset classes.

In a price-weighted index, the index level is calculated as the sum of constituent prices divided by a divisor. When a stock split occurs, the price of the affected security declines mechanically even though there is no change in the companys economic value. To prevent the index level from artificially changing, the divisor must be adjusted. In contrast, market-capitalization and equal-weighted indexes do not require divisor adjustments for stock splits because the total market value remains unchanged.

An equal-weighted index assigns the same weight to every security, regardless of size. In contrast, a market-capitalization-weighted index assigns larger weights to larger companies. If smaller-cap stocks outperform larger-cap stocks, the equal-weighted index will benefit more because it gives relatively greater weight to smaller firms. Stock splits do not affect relative performance, and dividends do not explain differences in price return calculations.