CFA 2018 r20 market indexes and benchmarks

Level III Market Indexes and Benchmarks www.ift.world Graphs, charts, tables, examples, and figures are copyright 2014, CFA Institute Reproduced and republished with permission from CFA Institute All rights reserved Overview and Introduction Introduction Distinguishing between a Benchmark and a Market Index Benchmark Uses and Types Market Indexes Uses and Construction Index Weighting Schemes: Advantages and Disadvantages Benchmark Selection: An Example www.ift.world 2 Distinguishing between a Benchmark and a Market Index Benchmark Market Index Oxford Dictionary: “a standard or point of reference against which things may be compared” A market index represents the performance of a specified security market, market segment, or asset class A standard or point of reference for evaluating the performance of an investment portfolio Can be used as a benchmark Market indexes have a wide variety of uses Benchmark should be specific to a particular manager’s investment process Unambiguous, investable, measurable, appropriate, reflective of current investment opinions, specified in advance, and accountable (“owned”) www.ift.world 3 Benchmark Uses and Types Users of benchmarks: plan sponsors and fund managers Uses of benchmarks: • reference points for segments of the sponsor’s portfolio; • communication of instructions to the manager; • communication of instructions to a board of directors (or any oversight group) and consultants; • identification and evaluation of the current portfolio’s risk exposures; • interpretation of past performance and performance attribution; • manager appraisal and selection; • marketing of investment products; and • demonstration of compliance with regulations, laws, or standards www.ift.world Types of Benchmarks • Absolute (including target) return benchmarks • Manager universes (peer groups) • Broad market indexes • Style indexes • Factor-model-based benchmarks • Returns-based (Sharpe style analysis) benchmarks • Custom security-based (strategy) www.ift.world Liability-Based Benchmarks • Particularly important for investors who invest with the chief objective of providing for the payment of a stream of liabilities • Match the duration profile and other key characteristics of the liabilities • Typically consists of nominal bonds, real return bonds, common shares, and other assets • Unlike 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 Investment success relative to such a benchmark is linked with achieving the objective of funding liabilities; by contrast outperformance of a market index used as a benchmark would not imply anything about the portfolio’s ability to fund liabilities www.ift.world Market Indexes Uses and Construction A popular method of assessing portfolio managers is to compare their returns with those of a market index “Currently, there are thousands of market indexes available for more than 70 countries, spanning developed markets, such as the United States; emerging markets, such as Brazil; and smaller frontier markets, such as Kazakhstan Indexes are created by traditional providers (e.g., MSCI), as well as exchanges (e.g., Euronext) and investment banks (e.g., Barclays) Equity indexes were the first to be developed but were soon followed by bond and alternative asset indexes” This section focuses on: Uses of Market Indexes Construction of Market Indexes www.ift.world 4.1 Use of Market Indexes • Asset allocation proxies • Investment management mandates • Performance benchmarks • Portfolio analysis • Gauge of market sentiment • Basis for investment vehicles www.ift.world 4.2 Index Construction • Define eligible securities • Define index weighting – – – – Capitalization weighting Price weighting Equal weighting Fundamental weighting • Determine index maintenance rules www.ift.world 4.3 Index Construction Tradeoffs • Completeness vs investability • Reconstitution and rebalancing frequency vs turnover • Objective and transparent rules vs judgment www.ift.world 10 Index Weighting Schemes: Advantages and Disadvantages Capitalization Price Equal Objective way of measuring the relative importance of constituents Simplicity of construction Smaller weight to large cap stocks than indexes formed by cap weighting Only index type that all investors could hold (macro-consistency); all investors in a CAPM world would hold a proportional investment in the market portfolio Long historical track record Better represent “how the market did” Automatic rebalancing Influenced by overpriced securities May be overly concentrated Overly influenced by highestpriced securities Treatment of stock splits Assumes investor holds one unit of each security www.ift.world Smaller-issue bias Frequent rebalancing and high transaction costs: strong performing stocks must be sold weak performers must be bought 11 Index Weighting Schemes: Advantages and Disadvantages Capitalization Fundamental Not influenced by overpriced securities because weight is based on a fundamental factor More representative of issuer’s importance in the economy Influenced by overpriced securities May be overly concentrated Reflect index creator’s view of valuation Less diversified if valuation screen is restrictive Not all investors could hold a fundamental-weighted index because they are weighted by valuation metrics, not by available liquidity (market capitalization) The construction methodology used by these indexes is usually proprietary Just because fundamental-weighted indexes have outperformed capitalization-weighted indexes in certain past time periods does not mean they will in the future and, more importantly, does not indicate that they are useful indexes www.ift.world 12 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 www.ift.world 13 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 • A capitalization-weighted index is usually only valid as a benchmark when the manager takes a market-oriented approach or specifically tracks the index • “Market indexes are similar to Swiss Army knives” www.ift.world 14 Example: A Japanese Stock Market Index The Nikkei 225 index is a widely followed, price-weighted index of 225 large-cap Japanese stocks with a history extending back to 1950 It represents six sectors and 36 industries, with the largest sector being technology at 43% The ten largest companies represent 36% of its value It is reconstituted every October and excludes REITs and ETFs Stocks added to the index are chosen by a committee of academicians and market professionals for their liquidity and sector representation The changes to the index are announced before stocks are added or deleted Discuss the use of the Nikkei 225 as an asset allocation proxy, investment management mandate, performance benchmark, gauge of market sentiment, basis for an investment vehicle, and in portfolio analysis www.ift.world 15 Solution: The Nikkei 225 is widely-followed, represents a large portion of the Japanese equity market, and is diversified across many industries Thus, it is a good representation of Japanese equity market performance and would serve as a useful asset allocation proxy and gauge of market sentiment Regarding its usefulness for a specific investment manager or investment, we would evaluate it as an investment management mandate, as a performance benchmark, as a basis for an investment vehicle, and for its usefulness in portfolio analysis The index balances completeness and investability by selecting securities with wide industry representation and liquidity The index is reconstituted only once a year, so tracking it would not incur inordinate trading costs The index therefore has potential to serve as an investment vehicle However, investor seeking to track the index would need to be aware of several peculiarities First, price-weighted indexes assume an investor holds one unit of each index security, which is not how most investors form portfolios Second, the Nikkei 225 index may be overweighted by high-priced securities and sectors As of early 2014, the technology sector was almost half the index’s weight at 43% and the ten largest companies represented 36% of its value Third, the judgment of a committee is used to determine which securities are added or deleted Therefore, it may be difficult for investors to adjust tracking portfolios prior to the reconstitution announcement Securities would be bought at inflated prices or sold at deflated prices if the investor is unable to anticipate index changes For these reasons, the Nikkei 225 has limitations as an investment management mandate, performance benchmark, basis for an investment vehicle, or for use in portfolio analysis www.ift.world 16 Benchmark Selection: An Example In our discussion, we have emphasized that the benchmark should be constructed so as to be consistent with the portfolio’s objectives and the manager’s investment process We now provide an example to illustrate the selection of a benchmark Consider a pension fund with the following sponsor characteristics, portfolio objectives, and manager investment process: • The fund manager has full discretion over the portfolio and its benchmark creation The fund is tax exempt • The sponsor is a US technology company with cyclical earnings and the majority of its sales in Japan • The sponsor is highly levered and has recently experienced financial difficulties • The sponsor has made large contributions to the fund owing to increased life expectancies and wishes to avoid future required contributions • Ten years ago, interest rates dropped to historic lows, and the sponsor’s pension liability soared As a result, the company switched from a defined benefit plan to a defined contribution plan for new employees to limit its future pension liabilities • The plan is fully funded • The percentage of participants in the plan who are now retired and receiving their pensions is 40% The average duration of the liabilities is 12.5 years • The benefits are indexed to inflation Future benefits will also increase as wages for current employees increase • The plan contains a lump sum provision whereby retirees can take a cash distribution at retirement in lieu of future payments The plan will have to provide the required cash distributions at that time www.ift.world 17 Example (continued…) • • • • • • • The manager starts with the Barclays Global Government, Corporate, and Inflation-Linked bond indexes as the target for bonds Bonds will be used to provide liquidity and limit the risk exposure of the fund Bonds also have a low correlation with the sponsor’s cash flows A total return approach will be used to meet required liquidity; however, the equity portion of the portfolio will be tilted toward dividend-paying stocks Because the fund is tax exempt, capital gains are not favored over ordinary income The preference for dividend-paying stocks is also consistent with the manager’s belief that value stocks outperform growth stocks The equity portfolio will be composed of value stocks, identified as low-price-to-book stocks The manager starts with the MSCI World Index as the target for equities The manager believes that the Japanese equity market is overvalued The manager will also exclude Japanese stocks because of the sponsor’s dependency on Japan The manager will exclude technology stocks because of their high correlation with the sponsor’s cash flows www.ift.world 18 Solution: The ideal benchmark will be a custom security-based benchmark whose assets, securities, and their weighting are chosen to mimic the liabilities The construction of the benchmark will require a great deal of time and care Data on securities in the indexes and the plan’s characteristics and strategic investment objectives will be required A custom security-based benchmark would be constructed with the following attributes and features •The plan portfolio appears to have below-average ability to take risk because the manager prefers liquid, incomeproducing investments and the sponsor does not wish to make further contributions to the fund •The benchmark’s asset allocation and security weighting should reflect the plan’s liability duration of 12.5 years •Because pension benefits are indexed to inflation and future benefits will increase as the business grows in the future, the portfolio and benchmark will contain allocations to nominal bonds, inflation-indexed bonds, and equities •The Barclays Global Government, Corporate, and Inflation-Linked bond indexes are the initial bond universe From this universe, only investment-grade bonds and bonds with reasonable liquidity will be considered owing to the plan’s risk aversion and its need for liquidity •The MSCI World Index is the initial equity universe The equities selected for benchmark inclusion will be screened to ensure a composition of dividend-paying value stocks Stocks with a large exposure to Japan and the technology industry will be excluded •The benchmark will have a cash allocation that, together with income from the investments, is sufficient to meet the liquidity required by retirement benefits due within the next year •The preliminary benchmark should be reviewed for consistency with the plan objectives and modified as appropriate Once constructed, the benchmark will be rebalanced through time to reflect changes in the investment process and ensure that it is still consistent with the fund’s objectives For example, the liability duration will decline through time, or the manager may change his views on the relative attractiveness of value and growth stocks www.ift.world 19 Summary and Conclusion • Distinction between a benchmark and a market index • Benchmark uses and types • Market index uses and construction – Advantages/disadvantages of different weighting schemes – Tradeoffs • Learn how to identify an appropriate benchmark • If you come across unfamiliar terms, use common sense – “gross” and “net” versions of its global total return indices • Recognize that this is a high-level reading • Practice! www.ift.world 20 ...Overview and Introduction Introduction Distinguishing between a Benchmark and a Market Index Benchmark Uses and Types Market Indexes Uses and Construction Index Weighting Schemes: Advantages and Disadvantages... were soon followed by bond and alternative asset indexes This section focuses on: Uses of Market Indexes Construction of Market Indexes www.ift.world 4.1 Use of Market Indexes • Asset allocation... market index “Currently, there are thousands of market indexes available for more than 70 countries, spanning developed markets, such as the United States; emerging markets, such as Brazil; and