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

2018 Study Session # 9, Reading # 20

“MARKET INDEXES AND BENCHMARKS”
1. 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.

2. 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.

3. 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.

4. 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.

5. 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.