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

Market Indexes and Benchmarks IFT Notes Market Indexes and Benchmarks Introduction 2 Distinguishing Between a Benchmark and a Market Index Benchmark Uses and Types 3.1 Benchmarks: Investment Uses 3.2 Types of Benchmarks Market Indexes Uses and Construction 4.1 Use of Market Indexes 4.2 Index Construction 4.3 Index Construction Tradeoffs Index Weighting Schemes: Advantages and Disadvantages 5.1 Capitalization-Weighted Indexes 5.2 Price-Weighted Indexes 5.3 Equal-Weighted Indexes 5.4 Fundamental-Weighted Indexes 5.5 Choosing an Equity Index Weighting Scheme When an Index Is Used as a Benchmark 5.6 Market Indexes as Benchmarks 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 2017, CFA Institute Reproduced and republished with permission from CFA Institute All rights reserved Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or quality of the products or services offered by IFT CFA Institute, CFA®, and Chartered Financial Analyst® are trademarks owned by CFA Institute IFT Notes for the Level III Exam www.ift.world Page Market Indexes and Benchmarks IFT Notes 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 talks about index weighting schemes and the advantages and disadvantages of the different weighting schemes Finally, section covers a benchmark selection example from an exam perspective 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 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 IFT Notes for the Level III Exam www.ift.world Page Market Indexes and Benchmarks IFT Notes 3.1 Benchmarks: Investment Uses This section addresses LOb: LO.b: Describe investment uses of benchmarks Some uses of benchmarks are discussed below Use of Benchmarks Comments 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 Benchmark type Comments 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 IFT Notes for the Level III Exam www.ift.world Page Market Indexes and Benchmarks IFT Notes 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 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 Liabilitybased 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 offers an example of a pension fund for which a liability-based benchmark is an ideal fit 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 IFT Notes for the Level III Exam www.ift.world Page Market Indexes and Benchmarks IFT Notes 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 Use of Market Indexes Comments 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: Inclusion criteria Security weighting 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: Be incorporated, formed, or established in Canada File statements and disclosures with the relevant Canadian regulatory bodies, Have its primary stock exchange listing on the Toronto Stock Exchange IFT Notes for the Level III Exam www.ift.world Page Market Indexes and Benchmarks IFT Notes 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: Completeness vs investability Reconstitution and rebalancing frequency vs turnover 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 IFT Notes for the Level III Exam www.ift.world Page Market Indexes and Benchmarks IFT Notes 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 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 capitalizationweighted 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 percent of the components of the S&P 500, but IFT Notes for the Level III Exam www.ift.world Page Market Indexes and Benchmarks IFT Notes 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 IFT Notes for the Level III Exam www.ift.world Page Market Indexes and Benchmarks IFT Notes 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, fundamentallyweighted indexes may be less diversified than capitalization-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 capitalizationweighted 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 IFT Notes for the Level III Exam www.ift.world Page Market Indexes and Benchmarks IFT Notes 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 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 IFT Notes for the Level III Exam www.ift.world Page 10 Market Indexes and Benchmarks IFT Notes investability; reconstitution and rebalancing frequency vs turnover; objective and transparent rules vs judgment Summary a distinguish between benchmarks and market indexes; Benchmark:  A standard or point of reference for evaluating the performance of an investment portfolio  Benchmark should be specific to a particular manager’s investment process  It should be unambiguous, investable, measurable, appropriate, reflective of current investment opinions, specified in advance, and accountable (“owned”) 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, but all benchmarks are not necessarily market indices b describe investment uses of benchmarks; Reference point Guidance for fund managers Guidance for plan sponsors Identification of risk exposures Performance measurement and attribution Manager appraisal and selection Marketing Compliance Uses of Benchmarks Benchmarks provide plan sponsors with risk and return expectations for each asset class These reference points guide asset allocation decisions By choosing a benchmark, plan sponsors convey to fund managers how they expect funds to be invested 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 Benchmarks can be used to determine if a fund manager is straying from his declared investment style 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 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 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 Regulators may require that funds report historical returns relative to a benchmark IFT Notes for the Level III Exam www.ift.world Page 11 Market Indexes and Benchmarks IFT Notes c compare types of benchmarks; Absolute return Manager universe Broad market indexes Style indexes Factor-modelbased Returns-based Custom security-based Benchmark Types 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 This type of benchmarks is used when a fund manager is expected to outperform the median return among a group of peers 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) Components of a broad market index can be broken down into categories, such as value stocks and growth stocks, to create style indexes 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 benchmarks are similar to factor-model-based benchmarks The factors are the returns for various style indexes Such an benchmark represents the weighted average of asset class indexes that best explain or track a portfolio’s returns Managers often pursue specific investment strategies In such cases, it is inappropriate to measure a manager’s performance relative to a broad market index, or even a more narrowly-defined style index Rather, it is preferable to use a custom-built strategy benchmark d contrast liability-based benchmarks with asset-based benchmarks;    Liability-based benchmark o are particularly important for investors who invest with the chief objective of providing for the payment of a stream of liabilities o match the duration profile and other key characteristics of the liabilities o 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 Outperformance of a market index used as a benchmark would not imply anything about the portfolio’s ability to fund liabilities e describe investment uses of market indexes; Asset allocation proxies Investment mandates Uses of Market Indexes Indexes provide historical data for returns, risk (e.g., standard deviation), and correlations with other assets This information guides asset allocation decisions 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 IFT Notes for the Level III Exam www.ift.world Page 12 Market Indexes and Benchmarks IFT Notes 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 nondomestic indexes can be used to measure the effectiveness of a currency management strategy Gauge of market Because they include a broad representation of an asset class, the performance of a sentiment market index is used as a summary of “market sentiment” Basis for Exchange-traded funds, index funds and derivatives can be based on a market index The investment vehicles creator of an index charges licensing fees f discuss trade-offs in constructing market indexes; Tradeoffs In Constructing Market Indexes Increasing the number of component stocks in an index (i.e., making it more complete) will make it more representative of its market However, making an index more complete will require the addition of less investable stocks 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 More objective criteria make it easier for investors to predict when securities will be removed from or included in the index While a certain amount of judgment will always be required, index creators should strive for transparency and objectivity Completeness vs investability Reconstitution and rebalancing frequency vs turnover Objective and transparent rules vs judgment g discuss advantages and disadvantages of index weighting schemes; Capitalization Equal Price Fundamental Simplicity of construction Long historical track record Not influenced by overpriced securities because weight is based on a fundamental factor More representative of issuer’s importance in the economy Advantages Objective way of measuring the relative importance of constituents Only index type that all investors could hold Automatic rebalancing Smaller weight to large cap stocks than indexes formed by cap weighting Better represent “how the market did” IFT Notes for the Level III Exam www.ift.world Page 13 Market Indexes and Benchmarks IFT Notes Disadvantages Influenced by overpriced securities May be overly concentrated Smaller-issue bias Frequent rebalancing and high transaction costs: strong performing stocks must be sold weak performers must be bought Overly influenced by highest-priced securities Assumes investor holds one unit of each security Treatment of stock splits Reflect index creator’s view of valuation Less diversified if valuation screen is restrictive Not all investors could hold a fundamentalweighted index The construction methodology used by these indexes is usually proprietary h evaluate the selection of a benchmark for a particular investment strategy    A capitalization-weighted index is usually valid as a benchmark when the manager takes a marketoriented approach or specifically tracks the index However, capitalization-weighted, float-adjusted indexes may have several limitations for use as benchmarks o They might not be compatible with a manager’s investment approach o Some construction rules might be less transparent than desired o As an index is reconstituted, its composition changes over time, sometimes in non-predictable ways An equal weighted index is more appropriate relative to a capitalization-weighted index if: o weightage of securities in a portfolio must be in a narrow band and/or o portfolio has a small-cap bias in a sector dominated by large-cap stocks Examples from the curriculum 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.19 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 Solution: The Nikkei 225 is widely-followed, represents a large portion of the Japanese equity market, and is IFT Notes for the Level III Exam www.ift.world Page 14 Market Indexes and Benchmarks IFT Notes 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 Back to Notes IFT Notes for the Level III Exam www.ift.world Page 15 ... of peers IFT Notes for the Level III Exam www .ift. world Page Market Indexes and Benchmarks IFT Notes Broad market indexes A market index measures the performance of an asset class For example,... benchmark IFT Notes for the Level III Exam www .ift. world Page 11 Market Indexes and Benchmarks IFT Notes c compare types of benchmarks; Absolute return Manager universe Broad market indexes Style indexes. .. Notes for the Level III Exam www .ift. world Page 12 Market Indexes and Benchmarks IFT Notes Performance benchmarks Market indexes can be used to benchmark a manager’s performance If a single market