Level III MarketIndexesandBenchmarksSummary Graphs, charts, tables, examples, and figures are copyright 2016, CFA Institute Reproduced and republished with permission from CFA Institute All rights reserved Distinguishing between a Benchmark and a Market Index Benchmark Market Index A standard or point of reference for evaluating the performance of an investment portfolio A market index represents the performance of a specified security market, market segment, or asset class Benchmark should be specific to a particular manager’s investment process Can be used as a benchmark Unambiguous, investable, measurable, appropriate, reflective of current investment opinions, specified in advance, and accountable (“owned”) www.ift.world Uses of Benchmarks 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 Guidance for plan sponsors 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 Identification of risk exposures Performance measurement and attribution 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 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 www.ift.world Benchmark Types Absolute return Manager universe 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 Broad marketindexes 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-modelbased 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 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 Custom security- Managers often pursue specific investment strategies In such cases, it is inappropriate to measure a based 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 www.ift.world Liability-Based Benchmarks Liability-based benchmarks… • are 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 marketindexes 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 www.ift.world Uses of MarketIndexes 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 Marketindexes can be used to benchmark a manager’s performance If a single market index fails benchmarks 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 www.ift.world Tradeoffs In Constructing MarketIndexes Completeness vs investability 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 Reconstitution and rebalancing frequency vs turnover 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 More objective criteria make it easier for investors to predict when securities rules vs judgment 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 www.ift.world Index Weighting Schemes: Advantages and Disadvantages Capitalization Equal Price Fundamental Objective way of measuring the relative importance of constituents Smaller weight to large cap stocks than indexes formed by cap weighting Simplicity of construction Not influenced by overpriced securities because weight is based on a fundamental factor Only index type that all investors could hold Long historical track record Better represent “how the market did” More representative of issuer’s importance in the economy Automatic rebalancing Influenced by overpriced securities May be overly concentrated Smaller-issue bias Overly influenced by highest-priced securities Frequent rebalancing and high transaction Assumes investor holds one costs: strong performing unit of each security stocks must be sold weak performers must be Treatment of stock splits bought www.ift.world Reflect index creator’s view of valuation Less diversified if valuation screen is restrictive Not all investors could hold a fundamental-weighted index The construction methodology used by these indexes is usually proprietary Selection of a Benchmark for given Investment Strategy • A capitalization-weighted index is usually valid as a benchmark when the manager takes a market-oriented approach or specifically tracks the index • 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 nonpredictable ways • An equal weighted index is more appropriate relative to a capitalization-weighted index if: – weightage of securities in a portfolio must be in a narrow band and/or – portfolio has a small-cap bias in a sector dominated by large-cap stocks www.ift.world ...Distinguishing between a Benchmark and a Market Index Benchmark Market Index A standard or point of reference for evaluating the performance of an investment portfolio A market index represents the... 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. .. 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