2018 Study Session # 9, Reading # 20 “MARKET INDEXES AND BENCHMARKS” 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 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 BENCHMARK USES AND TYPES 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 Copyright © FinQuiz.com All rights reserved 2018 Study Session # 9, Reading # 20 3.2 Types of Benchmarks Absolute Return Benchmark Manager Universes (Peer Groups) Minimum target return that the manger is expected to beat (e.g 9%) Market neutral long-short funds are another example 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 Factor-Model-Based Benchmarks These indexes measure broad asset class performance Style indexes can be generated from market indexes by more narrowly defining investment styles These are constructed by examining the portfolio’s sensitivity to a set of factors Simplest form ⇒ market model Returns-Based Benchmarks Custom Security-Based (Strategy) 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.) 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 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 4.1 Use of Market Indexes Asset allocation proxy ⇒ provides the investor a tool to measure asset class ex-ante return, risk & correlations Investment management mandates ⇒ communicate the expectation of the asset owner to the portfolio manager Performance benchmark ⇒ indexes are often used as ex-post performance benchmarks & represent market return Portfolio analysis ⇒ indexes can be used for detailed portfolio analysis in addition to benchmarking the manger’s performance Gauge of market sentiment ⇒ The most common use of indexes is to gauge the market sentiment Basis for investment vehicles e.g index mutual funds, ETFs & derivatives Copyright © FinQuiz.com All rights reserved 2018 Study Session # 9, Reading # 20 4.2 Index Construction Inclusion Criteria Weighting Methodology Maintenance Rules 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 Price 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) 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 Fundamental 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 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.) Copyright © FinQuiz.com All rights reserved 2018 Study Session # 9, Reading # 20 4.3 Index Construction Tradeoffs Completeness v/s Investability Reconstitution and rebalancing frequency vs Turnover 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 ⇒ 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 INDEX WEIGHTING SCHEMES: ADVANTAGES AND DISADVANTAGES 5.1 Capitalization-Weighted Indexes Advantages Disadvantages Objective way of measuring the relative importance of the constituents Best representative of a typical investor’s opportunity set Less rebalancing required Overly influenced by overpriced securities Larger issues weighted most heavily May be not suitable for active managers & institutional investors 5.2 Price-Weighted Indexes Advantages Simple to construct Long historical track record Disadvantages Overly influenced by highest priced securities Downward bias due to stock-splits It does no describe how most investors form portfolios Copyright © FinQuiz.com All rights reserved 2018 Study Session # 9, Reading # 20 5.3 Equal-Weighted Indexes Advantages Disadvantages More diversified This index may better represent “how the market did” based on average returns Small issuer bias Frequent rebalancing & high transaction costs Liquidity issues 5.4 Fundamental-Weighted Indexes Advantages Disadvantages 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) 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 Copyright © FinQuiz.com All rights reserved ... reserved 201 8 Study Session # 9, Reading # 20 4 .3 Index Construction Tradeoffs Completeness v/s Investability Reconstitution and rebalancing frequency vs Turnover There must be tradeoff b/w completeness.. .201 8 Study Session # 9, Reading # 20 3. 2 Types of Benchmarks Absolute Return Benchmark Manager Universes (Peer Groups)... no describe how most investors form portfolios Copyright © FinQuiz. com All rights reserved 201 8 Study Session # 9, Reading # 20 5 .3 Equal-Weighted Indexes Advantages Disadvantages More diversified