CFA CFA level 3 volume III applications of economic analysis and asset allocation finquiz curriculum note, study session 9, reading 20

Market Indexes and Benchmarks INTRODUCTION A reference point used to evaluate the performance of a portfolio manager or investment portfolio is referred to Distinguishing between a Benchmark and a Market Index 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 sterlingdenominated 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: Unambiguous: The identities and weights of securities or factor exposures constituting the benchmark are clearly defined Investable: The benchmark should represent a passive investment alternative i.e an investor can always opt to forgo active management and simply hold the benchmark Measurable: The benchmark’s return can be readily calculated on a reasonably frequent basis Appropriate: The benchmark reflects the same risk as the manager and is consistent with the manager’s investment style or biases or area of expertise Reflective of current investment opinions: The manager has current investment knowledge (positive, negative, or neutral) of the securities or factor exposures constituting the benchmark can invest in all securities Specified in advance: The benchmark is specified prior to the start of an evaluation period and is known to all interested parties as Benchmark The benchmark selection depends on the objectives and constraints of the investor Owned/Accountable: The investment manager should agree to be evaluated against the chosen benchmark A plan sponsor (i.e trustee, company, or employer 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 Benchmark Uses and Types 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 3.1 Benchmarks: Investment Uses Benchmarks: 1) can be used as a reference point for segments of the sponsor’s portfolio; 2) can be used to convey sponsor’s expectations to the manager regarding expected risk and return and the way fund assets should be invested 3) can be used to convey the manager’s area of –––––––––––––––––––––––––––––––––––––– Copyright © FinQuiz.com All rights reserved –––––––––––––––––––––––––––––––––––––– FinQuiz Notes – Reading 20 Reading 20 4) 5) 6) 7) 3.2 Market Indexes and Benchmarks expertise and his investment style to the board of directors (or any oversight group) and consultants; can be used to identify and evaluate the risk exposures of the manager; can be used for performance attribution as well as for appraisal and selection of managers; can be used by regulators to determine the compliance with regulations, laws, or standards can be used to market investment products to potential investors by describing investment strategy to them 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): Rp = ap + βpRI + εp Where, Rp = periodic return on an account RI = 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 Types of Benchmarks 6) 1) 2) 3) 4) 5) FinQuiz.com Absolute Return Benchmarks: An absolute return can be a return objective e.g actuarial rate-of-return assumption or a minimum return target that the fund aims to exceed Manager universe (Peer groups): It refers to using the 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 Broad market indexes: It refers to using broad market indexes as benchmarks e.g S&P 500, Wilshire 5000 for U.S common stocks; the Lehman Aggregate and the Citigroup Broad InvestmentGrade (U.S BIG) Bond Indexes for U.S investmentgrade debt Style indexes: It refers to using specific portions of an asset category as benchmark e.g largecapitalization growth, large-capitalization value, small-capitalization growth, small-capitalization value, mid-capitalization growth and value common stock indexes are also available Factor-model-based benchmarks: Factor models 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, F1, F2, FK represent the values of factors 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 7) 8) Returns-based benchmarks (Sharpe style analysis): 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 small-cap value, smallcap growth, large-cap value, and large-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 bk in factor-model-based benchmarks) are forced to be non-negative and sum to These allocation weights represent the returns-based benchmark Custom security-based benchmarks: These 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 Liability-based benchmarks: These benchmarks are 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 Reading 20 Market Indexes and Benchmarks 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 4.1 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 Security weighting: Index construction varies 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 Index maintenance: Index maintenance refers to the adjustment of the index for changes in shares outstanding resulting from buybacks, secondary offerings, spinoffs, stock distributions 1) Use of Market Indexes a) Asset allocation proxies: A market index can be 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 b) Investment management mandates: Market index 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 c) Performance benchmarks: Indexes can be used as ex-post performance benchmarks for the manager d) Portfolio analysis: Market indexes can be used for more detailed portfolio analysis For example, currency-hedged and unhedged versions of nondomestic indexes can be used to evaluate the effectiveness of a currency management strategy e) Gauge of market sentiment: Market indexes indicate 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 f) Basis for investment vehicles: Market indexes are also used as a basis for investments, i.e index mutual funds, exchange-traded funds (ETFs), and derivatives 4.2 FinQuiz.com Index Construction Index is constructed based on the following three factors 2) 3) Types of Security Weighting: There are several weighting schemes commonly used: 1) Capitalization weighting (market value weighting, 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 valueweighted index In float-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 Reading 20 Market Indexes and Benchmarks Its 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 2) Price weighting: In this method, weight of each 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, Pi = 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 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 3) Equal weighting: In equal-weighting, each stock in 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 Equal-weighted indexes must be rebalanced periodically (e.g., quarterly) to reestablish the equal weighting because individual security returns will vary, causing security weights to drift from equal weights 4) 4.3 Fundamental weighting: In fundamental weighting, 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 Index Construction Tradeoffs a) Completeness vs investability: 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 FinQuiz.com 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 b) Reconstitution and rebalancing frequency vs 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 The more frequent the reconstitution, the 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) Rebalancing is less frequent for wider bands of float-adjustment because there is high probability of issue’s estimated free float to stay within the band c) Objective and transparent rules vs judgment: Some 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 Reading 20 Market Indexes and Benchmarks 5.1 Index Weighting Schemes: Advantages and Disadvantages Capitalization-Weighted Indexes Advantages: • Market prices and the number of tradable securities are unambiguous measures of value at a point in time • If all investors held all the securities in capweighted indexes in proportion to their market value, then investors will be able to hold all shares This property is referred to as macro consistency • Cap-weighted indexes reflect the concept of CAPM because all investors in a CAPM world would hold a proportional investment in the market portfolio • A capitalization-weighted index requires less rebalancing than other indexes because stock splits and other changes in the index composition are automatically adjusted Disadvantages: A capitalization-weighted index is biased • 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 A capitalization-weighted index is less diversified • 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 A value-weighted index may not be consistent • with a manager’s investment style Capitalization-weighted indexes overweight • overvalued issues and underweight undervalued issues 5.2 FinQuiz.com Price-Weighted Indexes Advantages: • Price-weighted indexes are simple to construct • Historical stock price data is easily available than market value data Disadvantages: • Price-weighted indexes are biased towards highest price stock (i.e higher priced stocks receive higher weights) and not necessarily reflect the • • 5.3 economic importance of issuing companies Price-weighted indexes are affected by stock splits, reverse splits and changes in index composition and thus require adjustments In price-weighted indexes it is assumed that investor holds one unit of each security in the index that does not explain how most investors form portfolios Equal-Weighted Indexes Advantages: • Equal-weighted indexes are less concentrated in large-cap securities and more diversified as they give smaller weights to large-cap securities (and larger weights to small-cap securities) • Equal-weighted indexes may better represent “how the market did” because they provide an average of all index security returns Disadvantages: • Equal-weighted indexes are biased towards small cap firms because they contain more small firms • Equal-weighted indexes require frequent periodic rebalancing which increases transaction costs • Equal-weighted indexes contain potentially illiquid stocks 5.4 Fundamental-Weighted Indexes Advantages: • Fundamental-weighted indexes not suffer from disadvantages of market value-weighted, price-weighted and equal-weighted indexes because they use valuation metrics to weight index constituents • Fundamental-weighted indexes more 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: • Fundamental-weighted indexes are based on subjective judgment • Fundamental-weighted indexes are less diversified than capitalization weighted indexes if the valuation screen is restrictive • Fundamental-weighted indexes cannot be held by all the investors because they are weighted by valuation metrics rather than available Reading 20 • • Market Indexes and Benchmarks liquidity (market capitalization) Fundamental-weighted indexes may not serve as valid benchmarks because their composition and weightings are not fully known to investors Fundamental-weighted indexes may not serve 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 FinQuiz.com .. .Reading 20 4) 5) 6) 7) 3. 2 Market Indexes and Benchmarks expertise and his investment style to the board of directors (or any oversight group) and consultants; can be used to identify and. .. secondary offerings, spinoffs, stock distributions 1) Use of Market Indexes a) Asset allocation proxies: A market index can be used to measure ex-ante return, risk, and correlations of an asset class... the volatility of the liabilities A liability-based benchmark typically consists of nominal bonds, real return bonds, common shares, and other assets Reading 20 Market Indexes and Benchmarks