A market index represents the performance of a specified security market, market segment, or asset class.. A market index may be used as a benchmark for an investment manager.. For examp
Trang 1Reading 20 Market Indexes and Benchmarks
–––––––––––––––––––––––––––––––––––––– Copyright © FinQuiz.com All rights reserved ––––––––––––––––––––––––––––––––––––––
A reference point used to evaluate the performance of
a portfolio manager or investment portfolio is referred to
as Benchmark The benchmark selection depends on the objectives and constraints of the investor
A market index represents the performance of a
specified security market, market segment, or asset
class For example, S&P 500 Index represents the
performance of 500 large-cap US equities; Barclays
Sterling Aggregate Bond Index represents the
performance of fixed-rate, investment-grade
sterling-denominated bonds A market index may be used as a
benchmark for an investment manager
Characteristics of a Valid Benchmark: A valid
benchmark should have the following seven properties:
securities or factor exposures constituting the
benchmark are clearly defined
passive investment alternative i.e an investor can
always opt to forgo active management and
simply hold the benchmark
readily calculated on a reasonably frequent
basis
risk as the manager and is consistent with the
manager’s investment style or biases or area of
expertise
manager has current investment knowledge
(positive, negative, or neutral) of the securities or
factor exposures constituting the benchmark can
invest in all securities
prior to the start of an evaluation period and is
known to all interested parties
should agree to be evaluated against the chosen benchmark
responsible for a public or private institutional investment plan) is responsible for determining the plan participation requirements, investment choices, contributions, and distributions
A fund manager is the professional manager of separate accounts or pooled assets or an external investment manager to whom management of a part of the sponsor’s assets is delegated
Active investment strategies seek to generate return in excess of market return The excess return is referred to
as the manager’s active return, and the variability of the active returns is referred to as active risk
Policy portfolio is a strategic asset allocation that determines the broad allocation of assets to stocks, bonds, and other types of securities within the fund to individual managers within the asset categories
Investment Style: A natural grouping of investment disciplines that has some predictive power in explaining the future variation of portfolio/fund returns across portfolios/funds is known as Investment Style
An ideal or “valid” benchmark can be used to evaluate
active investment management skills of the manager
Benchmarks can also be used to identify investment
manager’s investment universe and investment
discipline
Benchmarks:
the sponsor’s portfolio;
the manager regarding expected risk and return and the way fund assets should be invested
Trang 2expertise and his investment style to the board of
directors (or any oversight group) and
consultants;
exposures of the manager;
as for appraisal and selection of managers;
compliance with regulations, laws, or standards
potential investors by describing investment
strategy to them
be a return objective e.g actuarial rate-of-return
assumption or a minimum return target that the fund
aims to exceed
median manager or fund from a broad universe of
managers or funds as a performance evaluation
benchmark e.g fund that falls at the median when
funds are ranked in descending order
market indexes as benchmarks e.g S&P 500, Wilshire
5000 for U.S common stocks; the Lehman
Aggregate and the Citigroup Broad
Investment-Grade (U.S BIG) Bond Indexes for U.S
investment-grade debt
4) Style indexes: It refers to using specific portions of an
asset category as benchmark e.g
large-capitalization growth, large-large-capitalization value,
small-capitalization growth, small-capitalization
value, mid-capitalization growth and value common
stock indexes are also available
are used to analyze the portfolio’s sensitivity to a set
of factors (systematic sources of return e.g return for
a broad market index, company’s size, company
earnings growth, industry, and financial leverage)
Rp = ap + b1F1 + b2F2+…+ bKFK +εp
Where, F 1 , F 2 , F K represent the values of
factors 1 through K, respectively
The higher the sensitivity (bk), the greater positive
exposure to a specified factor the portfolio has and
consequently, the higher expected return, holding all
else equal
For example, in one-factor model, the return on a security, or a portfolio of securities, is regressed on the return on a broad market index (over a long period e.g
60 months):
Where,
R p = periodic return on an account
R I = periodic return on the market index
ap = “zero factor” term It represents the expected value
of Rp if the factor value was zero
βp = beta = sensitivity of the returns on the account to the returns on the market index
εp = residual return due to nonsystematic factors
These benchmarks are constructed using (1) the series of a manager’s account returns over specified periods and (2) the series of returns on several investment style indexes (e.g cap value, small-cap growth, large-small-cap value, and large-small-cap growth) over the same periods Using these return series, an allocation algorithm solves for the optimal set of allocation weights for investment style indexes that most closely track the account’s returns In this optimization process, portfolio’s sensitivities (similar to
be non-negative and sum to 1 These allocation weights represent the returns-based benchmark
benchmarks are constructed by selecting securities and weightings consistent with the manager’s investment process and client restrictions Since these benchmarks reflect manager’s investment strategy, they are also referred to as strategy benchmarks The benchmark is rebalanced periodically to ensure that it stays consistent with the manager’s investment practice Such benchmarks are preferred to use when the manager’s strategy cannot be closely matched to a broad market index or style index
constructed by selecting securities and weightings consistent with the duration profile and other key characteristics of the liabilities These benchmarks reflect the return required to meet the future obligations as well as mimic the volatility of the liabilities A liability-based benchmark typically consists of nominal bonds, real return bonds, common shares, and other assets
Trang 34 Market Indexes Uses and Construction
Market indexes for equities include CAC 40 (French), FTSE
100 (UK), or Dow Jones Industrial Average (US) etc Broad
market fixed-income indexes include Barclays, JP
Morgan, Markit, and S&P/Citigroup These market
indexes are used to assess portfolio managers’
performance
used to measure ex-ante return, risk, and
correlations of an asset class It can also be used to
determine the incremental expected return and risk
from adding a new asset to a portfolio In other
words, market indexes allow investors to design an
investment policy suitable for different risk aversion
levels
can be used to convey the investment
management mandate of the plan sponsor to
portfolio manager For example, a portfolio
manager of a passively managed portfolio may be
required to match the index return; whereas, a
portfolio manager of an actively managed portfolio
may be required to generate returns in excess of an
index return
ex-post performance benchmarks for the manager
more detailed portfolio analysis For example,
currency-hedged and unhedged versions of
non-domestic indexes can be used to evaluate the
effectiveness of a currency management strategy
daily (and even intra-day) market movements
Hence, they can be used to gauge public or market
sentiments E.g the Chicago Board Options
Exchange (CBOE) Market Volatility Index (VIX) is
frequently used to measure market uncertainty
also used as a basis for investments, i.e index mutual
funds, exchange-traded funds (ETFs), and
derivatives
Index is constructed based on the following three
factors
1) Inclusion criteria: Inclusion criteria determine the number and type of eligible securities to be added
in the index The greater the number of securities and the more diversified they are by industry and size, the better the index will measure broad market performance Securities are considered eligible if they meet liquidity standards, minimum trading price, available shares (float), etc An index can serve as a valid benchmark if its security composition
is similar to that of the portfolio of the manager
depending on the methodology used for security weighting e.g value-weighting, price-weighting etc Weights of securities affect index risk and return and also influence the validity of the index as a
manager’s benchmark
the adjustment of the index for changes in shares outstanding resulting from buybacks, secondary offerings, spinoffs, stock distributions
Types of Security Weighting: There are several weighting schemes commonly used:
market cap weighting, or cap weighting): In market-value weighting, each stock in the index is weighted according to its market capitalization A market value-weighted index is estimated by adding the total market value of all the stocks in the index:
Market Value of stock = Number of Shares Outstanding ×
Current Market Price of stock
The performance of a market value-weighted index
represents the buy/hold return of all the outstanding shares of each stock in the index Examples of market
value-weighted index include S&P 500 and Nasdaq Composite, Russell 3000
Float-weighted index is a subcategory of market value-weighted index In float-value-weighted index, weights are assigned according to the market capitalization of publicly-traded (free float) shares only
Weight of a stock = Market cap weight × Free-float
adjustment factor
Where, Free-float adjustment factor = fraction of shares that float freely
Trang 4Its performance represents the buy/hold return of all the
shares of each stock in the index that are available for
trading to the public Examples include FTSE 100, Russell
1000 & 2000, S&P 500 etc
stock is assigned according to its absolute share
price A price-weighted index (PWI) is simply an
arithmetic average of current prices
PWI = (P1+P2+…+Pn) / n
Where,
P i = price of stock i
n = total number of stocks in the index
The performance of a price-weighted index represents
the buy/hold return of 1 share of each stock (or equal
number of shares invested in each stock) in the index
Index movements are affected by the change in the
prices of the stocks It is adjusted for stock splits and
changes in the composition of index over time
Examples include Dow Jones Industrial Average (DJIA)
and Nikkei Dow Jones Average
the index is weighted equally regardless of their
price or market value i.e a $25 stock is as
important as a $50 stock in the index and the total
market value of the company is not important The
performance of equal-weighting index represents
the buy/hold return of equal dollar amount
invested in shares of each stock in the index
Examples include Value Line and the Financial
Times Ordinary Share Index
periodically (e.g., quarterly) to reestablish the
equal weighting because individual security
returns will vary, causing security weights to
drift from equal weights
each stock in the index is weighted based on
company characteristics other than market values,
i.e sales, cash flow, book value, and dividends The
performance of a fundamental-weighted index
represents the performance of a portfolio that
invests according to valuation metrics for security
A benchmark should include every possible security
in order to reflect complete coverage of a market
But small-capitalization securities are too illiquid and
could not be purchased in amounts relevant to
institutional investors Similarly, some securities are
not accessible for foreign investors if country’s
government imposes restrictions A less broad index
is more investable and accessible but not a representative of broader, more diversified performance Hence, indexes must be designed in a way so that they are broad and have adequate investability Popular indexes have greater liquidity and thus they involve lower trading costs
turnover:
Reconstitution is the process of periodically adding and dropping securities from an index in order to keep pace with changes in index contents
Rebalancing involves adjusting weights of existing securities for changes in the number of shares outstanding There is also conflict inherent in maintaining an index‘s representativeness while at the same time seeking to maintain its simplicity and cost-efficiency because both reconstitution and rebalancing result in turnover which is costly for investors Security prices rise when securities are added to an index and fall when they are deleted from an index As a result, index reconstitution decreases returns of managers tracking the index because they have to buy securities at higher prices and sell the deleted securities at lower prices
better the index‘s representation of the pure market, but the greater the transaction costs in tracking the index
Reconstitution is less frequent for all-inclusive indexes than for those with a fixed number of securities where securities are added and dropped from an index on periodic basis (e.g., the S&P 500)
float-adjustment because there is high probability of issue’s estimated free float to stay within the band
broad-cap indexes of the U.S equity market are constructed using rules that are reasonably objective, while others are constructed using judgment Transparency and objectivity allow investors to anticipate changes in index constituents and to manage the index replication process in an orderly and efficient manner Less transparency and greater use of judgment make the index less
investable and create additional costs for tracking portfolios but at the same time, judgment-based indexes are considered to be superior in terms of stability, accurate representation of the industry distribution of the economy, and other attributes
Trang 55 Index Weighting Schemes: Advantages and Disadvantages
Advantages:
securities are unambiguous measures of value at
a point in time
• If all investors held all the securities in
cap-weighted indexes in proportion to their market
value, then investors will be able to hold all
shares This property is referred to as macro
consistency
CAPM because all investors in a CAPM world
would hold a proportional investment in the
market portfolio
rebalancing than other indexes because stock
splits and other changes in the index
composition are automatically adjusted
Disadvantages:
towards the shares of firms with the largest
market caps (mostly large, mature firms and
overvalued/overpriced firms) i.e companies with
larger market values have higher weights
Hence, the capitalization-weighted index is
potentially more vulnerable to market bubbles
as it is highly concentrated in few issues i.e large
cap firms Therefore, it may not serve as a valid
benchmark for those professionally-managed
portfolios that are prohibited to invest more than
10% of their value in any one stock in order to
meet professional fiduciary duty regarding
diversification
with a manager’s investment style
overvalued issues and underweight undervalued
issues
Advantages:
market value data
Disadvantages:
price stock (i.e higher priced stocks receive higher
weights) and do not necessarily reflect the
economic importance of issuing companies
reverse splits and changes in index composition and thus require adjustments
investor holds one unit of each security in the index that does not explain how most investors form portfolios
Advantages:
large-cap securities and more diversified as they give smaller weights to large-cap securities (and larger weights to small-cap securities)
“how the market did” because they provide an average of all index security returns
Disadvantages:
small cap firms because they contain more small firms
periodic rebalancing which increases transaction costs
illiquid stocks
Advantages:
from disadvantages of market value-weighted, price-weighted and equal-weighted indexes because they use valuation metrics to weight index constituents
appropriately represent an issuer’s importance in
an economy because they weight by fundamentals, rather than by market prices that are subject to bubbles
Disadvantages:
subjective judgment
diversified than capitalization weighted indexes if the valuation screen is restrictive
by all the investors because they are weighted
by valuation metrics rather than available
Trang 6liquidity (market capitalization)
as valid benchmarks because their composition
and weightings are not fully known to investors
as valid benchmarks for investors preferring
large-cap growth securities because they are
biased towards small-cap value stocks
Among all the types of indexes, capitalization-weighted,
float-adjusted indexes are considered to be the most
preferred for use as benchmarks because they are most
easy to mimic and involve less tracking risk and cost
End of Reading Practice Problems:
Practice all the questions given at
the end of Reading