CFA 2018 level 3 schweser practice exam CFA 2018 level 3 question bank CFA 2018 CFA 2018 r20 market indexes and benchmarks IFT notes

Distinguishing Between a Benchmark and a Market Index This section addresses LOa: LO.a: Distinguish between benchmarks and market indexes Benchmark According to the Oxford English dict

Market Indexes and Benchmarks

1 Introduction 2

2 Distinguishing Between a Benchmark and a Market Index 2

3 Benchmark Uses and Types 2

3.1 Benchmarks: Investment Uses 3

3.2 Types of Benchmarks 3

4 Market Indexes Uses and Construction 4

4.1 Use of Market Indexes 5

4.2 Index Construction 5

4.3 Index Construction Tradeoffs 6

5 Index Weighting Schemes: Advantages and Disadvantages 7

5.1 Capitalization-Weighted Indexes 7

5.2 Price-Weighted Indexes 8

5.3 Equal-Weighted Indexes 8

5.4 Fundamental-Weighted Indexes 9

5.5 Choosing an Equity Index Weighting Scheme When an Index Is Used as a Benchmark 9

5.6 Market Indexes as Benchmarks 9

6 Benchmark Selection: An Example 10

Summary 11

Examples from the curriculum 14

Example: A Japanese Stock Market Index 14

This document should be read in conjunction with the corresponding reading in the 2018 Level III CFA® Program curriculum Some of the graphs, charts, tables, examples, and figures are copyright

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1 Introduction

In this reading we will look at market indices and benchmarks In section 2, we will distinguish between

a benchmark and a market index In section 3, we will discuss the uses of benchmarks and the different types of benchmarks In section 4, we will focus on the uses of market indices and how to construct different kinds of market indices Section 5 talks about index weighting schemes and the advantages and disadvantages of the different weighting schemes Finally, section 6 covers a benchmark selection example from an exam perspective

2 Distinguishing Between a Benchmark and a Market Index

This section addresses LOa:

LO.a: Distinguish between benchmarks and market indexes

Benchmark

According to the Oxford English dictionary a benchmark is a standard or point of reference against which things may be compared This is a generic definition From an investment context, a benchmark can be defined as a standard point of reference for evaluating the performance of an investment portfolio The benchmark should be specific to a particular manager's investment process For example, if a pension fund hires a manager to invest in large-cap Japanese stocks, it would be appropriate to compare her performance relative to the Nikkei 225 index However, if the pension fund hires a manager to invest

in small-cap Japanese growth stocks, the Nikkei 225 index would not be an appropriate benchmark The properties of a valid benchmark are: It should be unambiguous, investable, measurable,

appropriate, reflective of current investment opinions, specified in advance, and accountable

Market Index

A market index represents the performance of a specified security market, market segment, or asset class A market index can be used as a benchmark In the above example, we saw that Nikkei 225 index can be used as a benchmark for a manager who invests in large-cap Japanese stocks

However to use an index as a benchmark we need to ensure that the market index is indeed reflecting

an investment manager’s process All market indexes can be benchmarks, but not all benchmarks are

market indexes

3 Benchmark Uses and Types

For the purpose of this reading, it is helpful to adopt the context of an institutional investor such as a pension plan Plan sponsors oversee the management of large pools of funds and may allocate portions

of these funds to different fund managers to invest

Plan sponsors may ask fund managers to invest passively, which involves closely tracking the returns on

a market index Alternatively, fund managers may be given a mandate to pursue an active investment strategy, which involves taking active risk in pursuit of active returns above a relevant benchmark

3.1 Benchmarks: Investment Uses

This section addresses LOb:

LO.b: Describe investment uses of benchmarks

Some uses of benchmarks are discussed below

Reference point Benchmarks provide plan sponsors with risk and return

expectations for each asset class These reference points guide asset allocation decisions

Guidance for fund managers By choosing a benchmark, plan sponsors convey to fund managers

how they expect funds to be invested

Guidance for plan sponsors When multiple managers are used, plan sponsors can use the

various benchmarks to determine if they are over or under-exposed

to certain sectors or asset classes

Identification of risk exposures Benchmarks can be used to determine if a fund manager is straying

from his declared investment style

Performance measurement and

attribution

Determining whether a manager has generated excess returns requires a benchmark to serve as a basis for comparison

Additionally, a manager’s performance can be attributed to factors such as sector allocation and security selection

Manager appraisal and

selection

Plan sponsors are continually evaluating how well fund managers are performing Managers currently entrusted with funds may be fired and replaced with new managers In making such decisions, plan sponsors will refer to benchmarks

Marketing Fund managers can use their performance relative to a benchmark

when marketing to potential clients In fact, the Global Investment Performance Standards (GIPS®) require such disclosure

Compliance Regulators may require that funds report historical returns relative

to a benchmark

3.2 Types of Benchmarks

LO.c: Compare types of benchmarks

Various types of benchmarks are discussed below

Absolute return A minimum return expressed either as a fixed percent or as a

spread above a floating benchmark This type of benchmarks is commonly used for market-neutral long-short investment strategies

Manager universe This type of benchmarks is used when a fund manager is expected

to outperform the median return among a group of peers

Broad market indexes A market index measures the performance of an asset class For

example, the S&P 500 is typically used to measure the performance

of US equities (broadly defined)

Style indexes Components of a broad market index can be broken down into

categories, such as value stocks and growth stocks, to create style indexes

Factor-model-based A portfolio’s sensitivity to one or more economic factors is

calculated based on a regression analysis of past returns Expected values for each factor are then plugged into a formula to determine

the return that the portfolio should generate given the factor

exposures

Returns-based Returns-based benchmarks are similar to factor-model-based

benchmarks in that the factors used to determine a portfolio’s expected return are various style indexed The resulting benchmark

is essentially a weighted average of the composite style indexes Custom security-based Managers often pursue specific investment strategies In such

cases, it may be inappropriate to measure a manager’s performance relative to a broad market index, or even a more narrowly-defined style index Rather, it may preferable to use a custom-built strategy benchmark

Note that all of the indexes in this section are discussed further in Evaluating Portfolio Performance,

Section 5.3

The remainder of this section addresses LOd:

LO.d: Contrast liability-based benchmarks with asset-based benchmarks

Recall from Linking Pension Liabilities to Assets, Section 1 that investors can adopt either an “asset-only”

(AO) or “asset liability management” (ALM) perspective The benchmarks discussed earlier in this

section are suited to AO investors, who assume that their liabilities are not exposed to market risk For ALM investors, notably defined benefit pension plans, the risk of failing to meet liability obligations

is a much greater concern than the risk of failing to outperform a benchmark In such cases, it is

necessary to build a benchmark that captures the market risk to which liabilities are exposed Liability-based benchmarks are composed of assets such as nominal bonds, real rate bonds, and equities The benchmark should mimic the market-related exposures faced by investors with significant liabilities The case in Section 6 offers an example of a pension fund for which a liability-based benchmark is an ideal fit

4 Market Indexes Uses and Construction

As discussed in Section 3.2, market indexes are just one type of benchmark and are not appropriate in every case Nevertheless, many plan sponsors use market indexes as a benchmark

4.1 Use of Market Indexes

This section addresses LO.e:

LO.e: Describe investment uses of market indexes

Some uses of market indexes are discussed below

Asset allocation proxies Indexes provide historical data for returns, risk (e.g., standard

deviation), and correlations with other assets This information guides asset allocation decisions

Investment mandates If a passive strategy is used, a manager’s mandate is to track the

index as closely as possible If an active strategy is used, the index serves as a starting point from which the manager will deviate based on his area of expertise

Performance benchmarks Market indexes can be used to benchmark a manager’s

performance If a single market index fails to adequately capture a manager’s style or strategy, a weighted-average combination of indexes may be considered

Portfolio analysis In addition to benchmarking the manager’s performance, indexes

can be used for more detailed portfolio analysis For example, currency-hedged and unhedged versions of non-domestic indexes can be used to measure the effectiveness of a currency

management strategy

Gauge of market sentiment Because they include a broad representation of an asset class, the

performance of a market index is used as a summary of “market sentiment”

Basis for investment vehicles Exchange-traded funds, index funds and derivatives can be based

on a market index The creator of an index charges licensing fees

4.2 Index Construction

The three key considerations when constructing an index are:

1 Inclusion criteria

2 Security weighting

3 Index maintenance

Define eligible securities

When choosing what securities to include, it is necessary to consider an index’s objective For example, the objective of the S&P/TSX Composite® index is to be “representative of the Canadian equity market and its sectors” In order to be considered “Canadian”, a company must:

1 Be incorporated, formed, or established in Canada

2 File statements and disclosures with the relevant Canadian regulatory bodies,

3 Have its primary stock exchange listing on the Toronto Stock Exchange

4 Have a “substantial presence in Canada”, which may include either its head office or “a

substantial portion of its fixed assets and revenues”

Additional requirements for inclusion in the S&P/TSX Composite® index include minimum levels of liquidity and market capitalization

Define index weighting

An index’s returns will be different depending on how component securities are weighted The most commonly-used index weighting schemes are capitalization weighting and price weighting Alternative weighting schemes include equal weighting and fundamental weighting

Descriptions of these weighting schemes – as well as discussions of the advantages and disadvantages each – are provided in Section 5, which addresses LO.g

Define index maintenance rule

In order to continue to be representative of its market, an index requires continual maintenance For example, index creators will need to make decisions about how often to rebalance the weights of an index’s component stocks Additional decisions will be required with respect to whether to remove and replace certain stocks Such maintenance considerations are discussed in Section 4.3

4.3 Index Construction Tradeoffs

LO.f: Discuss tradeoffs in constructing market indexes

Key tradeoffs to consider when constructing and maintaining a market index include:

1 Completeness vs investability

2 Reconstitution and rebalancing frequency vs turnover

3 Objective and transparent rules vs judgments

Completeness vs investability

Indexes seek to represent specific markets Increasing the number of component stocks in an index (i.e., making it more complete) will make it more representative of its market For example, the Wilshire 5000 index provides the broadest representation of the US equity market However, making an index more complete will require the addition of less investable stocks For example, roughly 40 percent of the stocks included in the Wilshire 5000 are considered “untradeable”

It is important to distinguish between investability and liquidity A stock may be very liquid among domestic investors, but be uninvestable for foreign investors depending on applicable laws and

regulations

Reconstitution and rebalancing frequency vs turnover

As mentioned in Section 4.2, indexes need to be monitored in order to ensure that they continue to represent their market Accomplishing this objective will require periodic reconstitution, which is the process of removing and replacing certain stocks in an index For example, the Nikkei 225 index is reconstituted every October Even if the components of an index remain unchanged, their weights may need to be periodically rebalanced More frequent rebalancing and reconstitution will result in a more

representative index However, this will also result in higher transaction costs for investors seeking to track the index

Objective and transparent rules vs judgment

Ideally, index creators will publish clear, unambiguous rules about inclusion criteria More objective criteria make it easier for investors to predict when securities will be removed from or included in the index To the extent that reconstitution rules are not transparent and objective (i.e., based on

judgments), stocks will experience sharp price spikes when it is announced that they have been added

to an index Similarly, the sudden announcement that a stock has been dropped from an index will cause its price to plummet

Many indexes rely on the judgment of a committee rather than precise rules The example that appears

in Section 5.6 discusses the lack of transparency with respect to the reconstitution of the Nikkei 225 index While a certain amount of judgment will always be required, index creators should strive for transparency and objectivity

5 Index Weighting Schemes: Advantages and Disadvantages

This section addresses LO.g:

LO.g: Discuss advantages and disadvantages of index weighting schemes

5.1 Capitalization-Weighted Indexes

Capitalization-weighted (or value-weighted) indexes are based on the assumption that investors hold the entire value of each component security A float adjustment is often made to reflect the number of

shares that are available to be traded For example, in Equity Portfolio Management, Section 4.1

(Example 1), Wal-Mart’s market value is $209 billion in the unadjusted value-weighted index, but just

$106.6 billion in the float-adjusted value-weighted index This reflects the fact that 49% of Wal-Mart’s shares were held by the Walton family and not available to be publicly-traded

Advantages:

1) Market value is an objective measure of a security’s importance in an index

2) All investors can own a capitalization-weighted index with a free float adjustment This quality is referred to as “macro consistency” It is mathematically impossible for all investors to hold indexes that use other weighting schemes

3) Less rebalancing is required compared to price-weighted indexes, which must be rebalanced to adjust for changes in stock splits By contrast, capitalization-weighted indexes are based on market value, not price, and therefore adjust automatically to stock splits

Disadvantages:

1) Stocks with higher market value have greater influence on the performance of capitalization-weighted indexes Critics argue that this creates a bias toward over-valued stocks, which

prevents investors from accurately assessing the riskiness of a market

2) A relatively small number of stocks can account for a disproportionately large share of an index For example, 10 stocks accounts just 2 percent of the components of the S&P 500, but

represented 19 percent of the index’s market value in 2013

5.2 Price-Weighted Indexes

Price-weighted indexes assume that investors hold one unit of each component stock

Advantages:

1) Price-weighted indexes are easy to construct and easily understood

2) Many price-weighted indexes, such as the Dow Jones Industrial Average and Nikkei 225 index, have long historical track records

Disadvantages:

1) The performance of price-weighted indexes is disproportionately influenced by high-priced stocks Compared to market value, stock price is an arbitrary measure of relative economic importance

2) Stocks that split are given a smaller weighting in a price weighted index Ironically, this gives a stock less influence over the performance of the index at a time when its economic importance may be increasing

3) As mentioned, price-weighted indexes are based on the assumption that investors hold one unit

of each component stock Such an assumption is unrealistic

These disadvantages are illustrated in the context of the Nikkei 225 index in the Example that appears in Section 5.6

5.3 Equal-Weighted Indexes

Equal-weighted indexes assume that an equal amount of money is invested in each component security Put differently, the return on an equal-weighted index is the average of the returns on each component security

Advantages:

1) Component stocks have an equal influence on the performance of an equal-weighted index This

is an advantage over capitalization-weighted indexes, which are biased toward stocks with higher market value, and price-weighted indexes, which are biased toward stocks with higher prices

2) Because they have no value or price bias, equal-weighted indexes provide a better indication of overall market performance

Disadvantages:

1) Giving small-capitalization stocks the same weight as large-capitalization stocks may not provide

an accurate representation of relative economic importance

2) Frequent rebalancing is required in order to maintain an equal-weighting Strong performing stocks must be sold and poor performing stocks must be bought, which results in significant transaction costs for investors seeking to track the index

3) To the extent that the smaller-capitalization stocks included in an equal-weighted index are

illiquid, investors will incur higher transaction costs to trade these shares

5.4 Fundamental-Weighted Indexes

Fundamental-weighted indexes use measures such as P/E ratio to determine a security’s weighting Proponents argue that this measures a stock’s intrinsic value, which may be different than its market price

Advantages:

1) To the extent that they can identify and correct for overvalued stocks, fundamental-weighted indexes provide a more accurate representation of economic importance and performance Disadvantages:

1) As mentioned, market capitalization is an objective measure of a stock’s economic importance

By contrast, the values of stocks in fundamental-weighted indexes reflect a subjective judgment 2) To the extent that undervalued stocks are concentrated in a particular sector, fundamentally-weighted indexes may be less diversified than capitalization-fundamentally-weighted indexes

3) Not all investors could hold a fundamental-weighted index Note that this criticism is applicable

to any index that is not capitalization-weighted with a float adjustment

4) The methodology used to adjust market prices to reflect fundamental-value is typically

proprietary, which means that investors cannot know the component stocks and their relative weights

5) Proponents argue that fundamental-weighted indexes have outperformed

capitalization-weighted indexes in the past However, there is no assurance that such outperformance will be repeated More importantly, an index should be constructed to represent a market, not to achieve a certain level of performance

5.5 Choosing an Equity Index Weighting Scheme When an Index Is Used as a Benchmark

Capitalization-weighted, float-adjusted indexes are considered the best for use as benchmarks because they are the most easily mimicked with the least amount of tracking risk and cost

As performance benchmarks, capitalization-weighted indexes are superior to the other index types because they best tell us how a manager did relative to the entire market

5.6 Market Indexes as Benchmarks

A capitalization-weighted, float-adjusted index is the best benchmark for most managers; these indexes meet many of the criteria of a valid benchmark: easily measurable, unambiguous, specified in advance, and generally investable

However, capitalization-weighted, float-adjusted indexes may have several limitations for use as

benchmarks:

 Might not be compatible with a manager’s investment approach

 Some construction rules might be less transparent than desired

 As an index is reconstituted, its composition changes over time, sometimes in non-predictable

ways

It is important to note that market indexes are typically constructed with the objective of representing the economic performance of a broad market or asset class It would be inappropriate to use a broad market index to assess the performance of a fund manager who specializes in picking technology sector stocks A style benchmark, or even a custom-built strategy benchmark, would likely be preferable

Refer to Example: A Japanese Stock Market Index from the curriculum

6 Benchmark Selection: An Example

The case discussed in this section, as well as the example that appears in Section 5.6, address LO.h: LO.h: Evaluate the selection of a benchmark for a particular investment strategy

The important aspects of this case have been addressed in the relevant sections of this summary from the curriculum

 Benchmarks play key roles in the highly competitive investment management industry because most managers are hired, retained, and often compensated on the basis of their performance relative to a benchmark A poorly specified benchmark will result in performance measurement, attribution, and appraisal analyses that are invalid

 Although they are often used as benchmarks, market indexes are distinct from benchmarks Market indexes have a wide variety of uses whereas benchmarks should be specific to a particular manager’s investment process

 In addition to their use in performance measurement and attribution, benchmarks facilitate communication between sponsors, investment managers, and consultants; identify risk exposures; and assist with manager selection, marketing, and regulatory compliance

 Benchmark types include absolute return benchmarks, manager universes, broad market indexes, style indexes, factor-model-based benchmarks, returns-based benchmarks, custom security-based

 Liability-based benchmark can be contrasted with asset-based benchmarks A liability-based benchmark will match the duration profile and other key characteristics of the liabilities Unlike asset-based benchmarks such as market indexes in which the components’ weights typically reflect relative overall market values, in a liability-based benchmark component weights are determined based on the requirement that the benchmark closely track returns to the liabilities

 Market indexes are used for asset allocation, investment management mandates, performance benchmarks, portfolio analysis, gauges of market sentiment, and the basis for investment vehicles

 Market indexes can be capitalization-weighted, price-weighted, equal-weighted, or fundamental-weighted Although there are advantages and disadvantages to each weighting scheme, capitalization-weighting is generally the most appropriate methodology when indexes are used as benchmarks

 A capitalization-weighted index is typically only valid as a benchmark when the manager takes a market-oriented approach or specifically tracks the index

 When constructing an index, the creator must accept tradeoffs between completeness vs