Market indexes can be used as benchmarks.. DISTINGUISHING BETWEEN A BENCHMARK AND A MARKET INDEX Market index ⇒it represents the performance of a specified security market, segment or a
Trang 12018 Study Session # 9, Reading # 20
“MARKET INDEXES AND BENCHMARKS”
1 INTRODUCTION
Oxford English dictionary ⇒ Benchmark ⇒ a standard or point of reference against which things may be compared
Investment context ⇒ a standard for evaluating the performance of an investment portfolio
Benchmarks communicate information about an investment manager’s investment universe & investment discipline
Market indexes can be used as benchmarks
2 DISTINGUISHING BETWEEN A BENCHMARK AND A MARKET INDEX
Market index ⇒it represents the performance of a specified security market, segment or asset class
The constituents of indexes are selected for their appropriateness in representing the targeted market, segment or asset class
Market indexes are often used as benchmark by passive managers
Active managers usually follow investment disciplines that cannot be adequately described by a security market index
Benchmarks must be appropriate for the specific investor whereas market indexes have broad appeal
Valid benchmark should be unambiguous, investable, measureable, appropriate, reflective of current investment opinions, specified in advance & accountable
3.1 Benchmarks: Investment Uses
Benchmarks uses include the following:
Convey the sponsor’s expectations to the manager as to how the fund assets will be invested & their expected risk & return
Reference points for segments of the sponsor’s portfolio
Communicate to the board & external consultants the mangers’ area of expertise
Identification & evaluation of the current portfolio’s risk exposures
Attribution & appraisal of past performance
Manager appraisal & selection
Benchmarks are also used to market investment products to potential investors
Demonstration of compliance with regulation, laws & standards
3 BENCHMARK USES AND TYPES
Trang 23.2 Types of Benchmarks
Absolute Return Benchmark
Minimum target return that the manger is expected to beat
(e.g 9%)
Market neutral long-short funds are another example
Manager Universes (Peer Groups)
Broad group of managers with similar investment disciplines
Allow performance comparisons with other managers
Managers typically try to beat the median manager’s return
Broad Market Indexes
These indexes measure broad asset class performance
Style indexes can be generated from market indexes by more
narrowly defining investment styles
Factor-Model-Based Benchmarks
These are constructed by examining the portfolio’s sensitivity
to a set of factors
Simplest form ⇒ market model
Returns-Based Benchmarks
Similar to factor-model-based benchmarks in that portfolio
returns are related to a set of factors
Factors include the return for various style indexes (e.g small
cap value, large cap growth etc.)
Custom Security-Based (Strategy)
These are built to accurately reflect the investment discipline
of a particular investment manager
Developed through discussions & past exposure analysis
Liability-Based Benchmarks
These benchmarks are used by investors who invest to meet a stream of liabilities
Duration profile & other key characteristics are usually matched & weights are determined to closely track the returns to the liabilities
4 MARKET INDEXES USES AND CONSTRUCTION
Indexes represent the performance of securities in a market
Indexes played a key role in modern portfolio theory & are popular due to the success of low cost index funds
Trang 32018 Study Session # 9, Reading # 20
Weighting Methodology
4.2 Index Construction
Define Eligible Securities
The starting universe of securities must first be identified
To improve the investability of the index, various eligibility rules are applied
Index Weighting
Market Cap Weighting
Most common weighting scheme
Constituents are held in proportion to their market cap
The performance of a value-weighted index represents the
performance of a portfolio that holds all the outstanding value
of each index security
Usually such index is adjusted for free float (amount of shares
available to the public)
Price Weighting
Under this scheme constituents are weighted in proportion to their prices
Index value = Avg of the constituent prices
Performance of this index can be matched by constructing a portfolio that holds one unit of each index security
Equal Weighting
Equal weights to all constituents at specified rebalancing
times
It represents the performance of a portfolio that invests the
same amount of wealth in each index security
Must be rebalanced periodically
Fundamental Weighting
Company’s characteristics e.g sales, cash flows, book value are used to weight securities rather than market value under this weighting scheme
Performance according to valuation metrics
Determine Index Maintenance Rules
Variety of rules must be chosen by an index constructor to provide for ongoing maintenance of an index (e.g outstanding shares may change due to buy backs spin-off etc.)
Trang 44.3 Index Construction Tradeoffs
Completeness v/s Investability
There must be tradeoff b/w completeness & investability
Index designers must decide how broad their indexes can be
while maintaining investability
Investability is not the same as liquidity
Investability is an important concern when manager faces
frequent & uncertain withdrawals
Reconstitution and rebalancing frequency vs Turnover
Reconstitution ⇒ the process of adding & dropping securities from an index
Rebalancing ⇒ readjustment in the weights of existing securities
Index designers must decide how often to reconstitute &
rebalance their indexes while maintaining tolerable turnover
Objective and transparent rules vs Judgment
Index reconstitution ⇒ passive managers’ returns (they have
to buy added securities at higher price & vice versa)
Transparent & objective index ⇒ allow investors to readily predict the changes in index constituents that might occur
Index designers may exercise some degree of judgment in applying their methodologies
5.1 Capitalization-Weighted Indexes
Advantages
Objective way of measuring the relative importance of the
constituents
Best representative of a typical investor’s opportunity set
Less rebalancing required
Disadvantages
Overly influenced by overpriced securities
Larger issues weighted most heavily
May be not suitable for active managers & institutional investors
5 INDEX WEIGHTING SCHEMES: ADVANTAGES AND DISADVANTAGES
5.2 Price-Weighted Indexes
Trang 52018 Study Session # 9, Reading # 20
5.3 Equal-Weighted Indexes
Advantages
More diversified
This index may better represent “how the market did” based on average returns
Disadvantages
Small issuer bias
Frequent rebalancing & high transaction costs
Liquidity issues
5.4 Fundamental-Weighted Indexes
Advantages
It addresses the problem of overweighting the overvalued
issues & underweighting the undervalued issues as the case
with market-cap based index through valuation matrices
Represents an issuer’s importance in economy (less subject to
bubbles)
Disadvantages
Rely on subjective judgment of constructor
May be less diversified if valuation screen is restrictive
Liquidity issues
May not serve as valid benchmarks, tilted towards small-cap value stocks
May not suitable for large-cap or growth preference
5.5 Choosing an Equity Index Weighting Scheme When an Index Is Used as a Benchmark
Float adjusted indexes are considered the best for use as benchmarks because they are most easily mimicked with the least amount of tracking risk and lower cost
Non-cap weighted indexes ⇒ often used to seek returns in excess of cap-weighted index’s return
5.6 Market Indexes as Benchmarks
Float-adjusted indexes generally fulfill most validity criteria because they are easily measureable, unambiguous, specified in advance generally investable
Limitation of cap-weight, float-adjusted indexes:
May not compatible with a manager’s investment approach
Construction rules may be less transparent