Market Indexes and Benchmarks

Benchmark is 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.

A market index may be considered for use as a benchmark or comparison point for an investment manager; however, the most appropriate benchmark or reference point for an investment manager need not be, and often is not, an available market index.

Nonetheless, indexes can sometimes serve as valid benchmarks.

Valid benchmarks will be:

unambiguous,
investable,
measurable,
appropriate,
reflective of current investment opinions,
specified in advance, and
accountable (“owned”).

Given the uses described above, benchmarks are an important part of the investment process for both institutional and private wealth clients. The seven types of benchmarks are:
absolute (including target) return benchmarks;
manager universes (peer groups);
broad market indexes;
style indexes;
factor-model-based benchmarks;
returns-based (Sharpe style analysis) benchmarks; and
custom security-based (strategy).

An absolute return benchmark is simply a minimum target return that the manager is expected to beat. The return may be a stated minimum (e.g., 9%), stated as a spread above a market index (e.g., euro interbank offered rate + 4%), or determined from actuarial assumptions.

A manager universe—or manager peer group—is a broad group of managers with similar investment disciplines. Manager universe benchmarks allow investors to make comparisons with the performance of other managers. Managers are typically expected to beat the median manager return, which refers to the manager return that splits the sample of managers’ returns in half.

Returns-based benchmarks (Sharpe style analysis) are similar to factor-model-based benchmarks in that portfolio returns are related to a set of factors that do well in explaining portfolio returns. In the case of returns-based benchmarks, however, the factors are the returns for various style indexes (e.g., small-cap value, small-cap growth, large-cap value, and large-cap growth). The analysis produces a benchmark that is essentially the weighted average of these asset class indexes that best explains or tracks the portfolio’s returns.

Custom security-based benchmarks are built to accurately reflect the investment discipline of a particular investment manager. Such benchmarks are developed through discussions with the manager and an analysis of past portfolio exposures.
Custom security-based benchmarks are also referred to as strategy benchmarks because they should reflect the manager’s particular strategy. Custom security-based benchmarks are particularly appropriate when the manager’s strategy cannot be closely matched to a broad market index or style index.

A liability-based benchmark will match the duration profile and other key characteristics of the liabilities. A liability-based benchmark 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.

Used for asset allocation, an index constructed consistently over time provides the investor a tool to measure asset class ex ante return, risk, and correlations. It allows investors to determine the incremental expected return and risk from adding a new asset to a portfolio. These measurements can be used to design an investment policy suitable for different risk aversion levels.

As a result of their effectiveness as asset allocation proxies, investment mandates can include a specified benchmark index.

Indexes are often used as ex post performance benchmarks, where they answer the basic question, did the manager beat the market?

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.

Possibly the most common use of indexes is as a gauge of public or market sentiment. They answer the question, how did the market do today?

Indexes are also used as a basis for investments, such as index mutual funds, many exchange-traded funds (ETFs), and derivatives.

There are three primary choices in index construction:
Inclusion criteria: the first choice, the inclusion criteria, determines which specific population of securities the index represents.
Security weighting: the second choice, selecting the methodology for security weighting, is usually a choice among value, price, or another weighting scheme.
Index maintenance: the third choice relates to the index’s maintenance rules, which will influence the index’s performance and its applicability as a benchmark. One should be aware of such differences before comparing a manager’s portfolio to an index.

The general approach to constructing asset class indexes consists of creating rules for the following steps:
1. Define eligible securities. The starting universe of securities, such as all common equity shares of companies within a given country, must first be identified.
2. Define index weighting
3. Determine index maintenance rules. A variety of rules must be chosen by an index constructor to provide for ongoing maintenance of an index. For example, shares outstanding may change due to buybacks, secondary offerings, spinoffs, stock distributions, and so on. Index constructors typically handle these events as they occur, by specified rules.

also known as market value weighting, market cap weighting, or cap weighting. The most common weighting scheme used is capitalization weighting. In this scheme, constituents are held in proportion to their market capitalizations, calculated as price times available shares. The performance of a value-weighted index represents the performance of a portfolio that holds all the outstanding value of each index security. By far, market capitalization weighting has the greatest acceptance by investment professionals.

In this scheme, constituents are weighted in proportion to their prices. The index value thereby can be interpreted simply as an average of the constituent prices. The performance of a price-weighted index represents the performance of a portfolio that holds one unit of each index security. Although the advantage of price weighting is its simplicity, the scheme offers little relevance to the way most investors weight their portfolios.

In a pure equal-weighting scheme, all constituents are held at equal weights at specified rebalancing times. The performance of an equal-weighted index represents the performance of a portfolio that invests the same amount of wealth in each index security. Variations of this approach might weight groups of constituents (such as sectors or industries) equally. 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.

This weighting scheme uses company characteristics other than market values, such as sales, cash flow, book value, and dividends, to weight securities. By forming weights based on variables considered important (fundamental) for valuation, these indexes seek to weight securities using true values, rather than the market prices of capitalization and price weighting. The performance of a fundamental-weighted index represents the performance of a portfolio that invests according to valuation metrics for a security.