Benchmark Construction

October 2009

Contents
I. II. Dow Jones Industrial Average S&P 500 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 Styles V. Appendix

III. Russell Indexes

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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 bestknown 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 the index, 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 been necessary 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 C t / Ct Where: Divisor to be effective on trading session t+1 Dt+1 Dt Divisor on trading session t a Ct 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.
a

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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 the original 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 Alcoa American Express AT&T
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Date Added June 1, 1959 August 30, 1982 November 1, 1999 February 19, 2008 March 12, 1987 May 6, 1991 February 19, 2008 June 8, 2009 March 12, 1987 November 20, 1935 October 1, 1928 November 7, 1907 November 1, 1999 March 17, 1997 June 29, 1979 November 1, 1999 May 6, 1991 March 17, 1997 September 22, 2008 October 30, 1985 June 29, 1979 November 1, 1999 August 9, 1976 April 8, 2004 May 26, 1932 June 8, 2009 March 14, 1939 April 8, 2004 March 17, 1997 May 6, 1991

Replaced National Steel Manville Union Carbide Altria Group Inco Navistar International Honeywell International Citigroup Owens-Illinois Glass Borden Index expansion Tennessee Coal & Iron Sears, Roebuck Texaco Chrysler Goodyear Tire & Rubber Primerica Bethlehem Steel AIG American Brands Esmark Chevron Anaconda Copper Eastman Kodak United Air Transport General Motors Nash Kelvinator International Paper Woolworth USX

Bank of America Boeing Caterpillar Chevron Cisco Systems Coca-Cola DuPont ExxonMobil General Electric Home Depot Hewlett-Packard IBM Intel JPMorganChase Johnson & Johnson Kraft Foods McDonalds Merck Microsoft 3M Pfizer Procter & Gamble Travelers United Technologies Verizon Communications Wal-Mart Stores Walt Disney

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 equity market 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 required to 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 by total 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, or similar 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 Benchmark Construction
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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 frontrunning 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:
Companies Included (by market-cap rank) 1 4,000 1 3,000 1 200 201 1,000 1 1,000 1,001 3,000 501 3,000 2,001 4,000

Index Russell 3000E Index Russell 3000 Index Russell Top 200 Index Russell Midcap Index Russell 1000 Index Russell 2000 Index Russell 2500
TM

Index

Russell Microcap Index

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 growth characteristics 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 adding back 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 considered for 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% of the full market capitalization; this segment is not represented 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 capitalization cutoff 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 Market Cap Segment Definition Upside Buffer Zone Downside Buffer Zone 301-450 1-300

Mid Cap 301-750 201-300 751-1100

Small Cap 751-2500 551-750 2501-3000

Micro Cap

1851-2500

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: Value Z-Score + - or 0 + - or 0 Growth Z-Score - or 0 + + - or 0

Style
Value Growth Both 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 OFI Institutional 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. All rights reserved.

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