3. Market Indexes and Benchmarks

The FIRST CHOICE, the INCLUSION CRITERIA,

determines which specific population of securities the index represents. 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. A narrower universe will measure performance of a specific group of securities. To serve as a benchmark, the inclusion criteria for an index should result in security composition that is similar to the manager's portfolio.

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.

5. Index Weighting Schemes: Advantages and Disadvantages 5.4. Fundamental-Weighted Indexes Disdvantages

A disadvantage of fundamental-weighted indexes is that they reflect the index creator's view of valuation, which may or may not be correct. The fact that there are different methods of constructing fundamental-weighted indexes in the industry demonstrates that they rely on subjective judgment.

Liability Based Benchmarks (2)

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, COMMONS 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. Investment success relative to such a benchmark is linked with achieving the objective of funding liabilities; by contrast outperformance of a market index used as a benchmark would not imply anything about the portfolio's ability to fund liabilities. Bernstein (2000, p. 5) made an argument for liability-based benchmarks for investors in general.

2. manager universes (peer groups);

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. Manager universes are typically formed by asset class and the investment approach within that class. Hedge funds are often evaluated relative to manager universe benchmarks, provided by such vendors as Credit Suisse/Tremont, Hedge Fund Research, and Lipper/TASS. Private equity funds are also commonly evaluated in this way; examples of data vendors are Burgiss, Cambridge Associates, Preqin, and Thomson Venture Economics. Investment magazines are prolific providers of peer group comparisons for investment funds (e.g., mutual funds in the United States and unit trusts in the United Kingdom); thus, a mutual fund investing in global equities might be ranked among all mutual funds with similar objectives over various time periods.

Examples of when Market Index could also be used as a benchmark

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. A good example in which a market index is an appropriate benchmark is the case of passive managers, who typically invest in a portfolio similar (or identical) to a chosen market index so as to closely track its performance. An active US core equity manager whose investment universe is the S&P 500—that is, one that seeks to add value by under- or overweighting component securities of the S&P 500—might also use the S&P 500 as its benchmark.

2. Distinguishing between a Benchmark and a Market Index Market Index

A market index represents the performance of a specified security market, market segment, or asset class. For example, the FTSE 100 Index is an index constructed to represent the broad performance of large-cap UK equities. The constituents of each of these indexes are selected for their appropriateness in representing the targeted market, market segment, or asset class.

5.5. Choosing an Equity Index Weighting Scheme When an Index Is Used as a Benchmark

A natural categorization among indexes divides those that are cap weighted from those that are not. The objectivity, practicality, and theoretical underpinning of market capitalization weighting has made it the dominant scheme for constructing indexes. In most cases, benchmarks should be capitalization weighted and then float adjusted, reflecting the fact that most portfolio managers will take smaller positions in less available, less liquid securities. Of the index types examined, capitalization-weighted, float-adjusted indexes are considered the best for use as benchmarks because they are the most easily mimicked with the least amount of tracking risk and cost. The major equity index families published by FTSE, MSCI, Russell, and S&P and nearly all those published by S&P Dow Jones and Wilshire are cap weighted and float adjusted. Non-cap-weighted indexes are often proposed to seek return (or risk-adjusted return) in excess of that provided by a cap-weighted index. The primacy of cap-weighted indexes as benchmarks is supported by the fact that a cap-weighted return must be calculated in order to determine by how much an alternate strategy might exceed it. As performance benchmarks, capitalization-weighted indexes are superior to the other index types because, simply put, they best tell us how a manager did relative to everyone else (i.e., , the entire market). Price-weighted and equal-weighted indexes are best seen as particular market indicators that are generally not reasonable benchmarks. Fundamental-weighted indexes may or may not serve as viable investment strategies, but they do not serve the traditional representative role of an index and their proprietary nature means that it would be difficult to use them for manager evaluation. In sum, capitalization-weighted indexes are the most likely type of index to serve as a valid benchmark for an investor. The next question is how they fare against standards for benchmark validity. We next examine in more detail whether float-adjusted, capitalization-weighted indexes can serve as valid benchmarks.

5. Index Weighting Schemes: Advantages and Disadvantages 5.4. Fundamental-Weighted Indexes Disdvantage

A second disadvantage is that they may be less diversified than capitalization-weighted indexes if the valuation screen is restrictive.

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. Given these choices, index constructors will determine index values from which returns can be calculated. When creating an index, index providers face SEVERAL TRADEOFFS, which we examine next.

5. Interpretation of past performance and performance attribution;

ATTRIBUTE & APPRAISE past performance and the consequences of the manager's investment decisions. The benchmark helps the board and its consultants determine and evaluate the manager's excess return Return attribution identifies such things as whether the manager's security selection, industry bets (in equity analysis), or yield curve positioning (in fixed-income analysis) have added value. What caused the manager's performance to be different from the benchmark's? Performance appraisal's chief focus is to distinguish active investment SKILL from LUCK

1. absolute (including target) return benchmarks;

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. An example of an absolute return benchmark is 30% per annum return for a private equity investment (e.g., a buyout fund—note that more sophisticated benchmarks are available). Market neutral long-short equity funds are another example where absolute return benchmarks are used. Such funds are run by portfolio managers who believe that they can identify over- and undervalued shares. Such a fund consists of long and short positions in, respectively, perceived undervalued and overvalued equities and is constructed so that, overall, the portfolio is expected to be insensitive to broad equity market movements—that is, market neutral with a market beta of zero. Because a market neutral fund is in principle a zero-expected systematic risk investment, the benchmark may be specified as a three-month Treasury bill return; the investment objective may be to outperform the benchmark consistently by a given number of basis points.

Investment management mandates

As a result of their effectiveness as asset allocation proxies, investment mandates can include a specified benchmark index. The benchmark index for a mandate communicates the expectations of the asset owner (e.g., plan sponsor) to the portfolio manager: The portfolio manager is generally expected to select securities primarily from the constituents of the index. Exceeding an index return is frequently considered an objective of an actively managed portfolio (and matching the index return is the objective of a passively managed portfolio). Such an index will be valid as an evaluation tool, of course, only to the extent that it meets the criteria for a valid benchmark.

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.

3. communication of instructions to a board of directors (or any oversight group) and consultants;

Benchmark communicates to the BOARD and EXTERNAL consultants the manager's AREA OF EXPERTISE and how a manager should invest and be evaluated. In a multiple-manager fund, benchmarks convey the managers' coverage areas, so that assets and securities that lack coverage or are overemphasized can be identified

7. Marketing of investment products; and

Benchmarks are also used to MARKET INVESTMENT PRODUCTS to potential investors. The GIPS require that if a benchmark exists, it must be included in a performance presentation with its description. If no benchmark is provided, a reason must be given. Marketing requires the communication and explanation of the investment process, of which the benchmark is an essential descriptor of the investment strategy and a crucial determinant of excess returns. Excess returns have been found to be a significant determinant of investor inflows, so the choice of the benchmark will influence the fund's ability to attract new capital

8. Demonstration of compliance with regulations, laws, or standards.

Benchmarks are used to demonstrate compliance with regulations, laws, and standards. Regulatory organizations use benchmarks as part of their oversight and surveillance, and as a result, benchmarks have become mandated in many jurisdictions. In 1998, the US SEC introduced a requirement that mutual funds self-designate a benchmark and present their historical returns alongside it in the prospectus. Many other jurisdictions now have similar rules. More generally, institutions are sometimes restricted from investing in specific instruments, such as below-investment-grade bonds. Benchmarks for such institutions have to be tailored accordingly.

6. Manager appraisal and selection;

Benchmarks play a role in the manager selection processes because they will influence the perception of a manager's skill. The analysis of past performance will involve a qualitative assessment of whether the manager's investment process is robust enough to produce repeatable outperformance in the future or, alternatively, whether a manager's past underperformance is likely to persist.

Summary

Benchmarks play key roles in the highly competitive investment management industry because most managers are hired, retained, and often compensated on the basis of their performance relative to a benchmark. A poorly specified benchmark will result in performance measurement, attribution, and appraisal analyses that are invalid. Although they are often used as benchmarks, market indexes are distinct from benchmarks. Market indexes have a wide variety of uses whereas benchmarks should be specific to a particular manager's investment process. In addition to their use in performance measurement and attribution, benchmarks facilitate communication between sponsors, investment managers, and consultants; identify risk exposures; and assist with manager selection, marketing, and regulatory compliance. Benchmark types include absolute return benchmarks, manager universes, broad market indexes, style indexes, factor-model-based benchmarks, returns-based benchmarks, custom security-based. Liability-based benchmark can be contrasted with asset-based benchmarks. A liability-based benchmark will match the duration profile and other key characteristics of the liabilities. Unlike asset-based benchmarks such as 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. Market indexes are used for asset allocation, investment management mandates, performance benchmarks, portfolio analysis, gauges of market sentiment, and the basis for investment vehicles. Market indexes can be capitalization-weighted, price-weighted, equal-weighted, or fundamental-weighted. Although there are advantages and disadvantages to each weighting scheme, capitalization-weighting is generally the most appropriate methodology when indexes are used as benchmarks. A capitalization-weighted index is typically only valid as a benchmark when the manager takes a market-oriented approach or specifically tracks the index. When constructing an index, the creator must accept tradeoffs between completeness vs. investability; reconstitution and rebalancing frequency vs. turnover; objective and transparent rules vs. judgment

3. broad market indexes;

Broad market indexes are measures of broad asset class performance, such as the JP Morgan Emerging Markets Bond Index (EMBI) for emerging market bonds or the MSCI World Index for global developed market equities. Broad market indexes are well known, readily available, and easily understood. The number of market indexes has proliferated over time so as to serve a greater number and variety of applications and end users. For example, in 1999, JP Morgan created the EMBI Global index (EMBIG), which added less liquid issues and less creditworthy issues to the EMBI. The performance of broad market indexes is widely reported in popular media, such as television.

5. Index Weighting Schemes: Advantages and Disadvantages 5.1. Capitalization-Weighted Indexes Advantage (1)

Capitalization weighting is used in most market indexes for good reasons. First, weighting companies by market value is an objective way of measuring the relative importance of constituents, as it clearly measures the market's assessment of their relative values. A security's price is a consensus estimate of its value formed by a multitude of investors, rather than a single index creator's estimate. Market prices and the number of tradeable securities are unambiguous measures of value at a point in time.

7. custom security-based (strategy)

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. After the manager's investment process is identified, the benchmark is constructed by selecting securities and weightings consistent with that process and client restrictions. A cash weight is also identified that is appropriate for the situation. The benchmark is subsequently rebalanced on a periodic basis to ensure that it stays consistent with the manager's investment practice. 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.

5. factor-model-based benchmarks;

Factor-model-based benchmarks are constructed by examining the portfolio's sensitivity to a set of factors. Examples of factors include the return for a broad market index, company earnings growth, industry, and financial leverage. The simplest form of a factor-model-based benchmark is the market model, in which there is a single factor, the return on a broad market index. To determine the factor sensitivities, the portfolio's return is regressed against the factors believed to influence returns. The general form of a factor model Equation (1) Rp = ap + b1F1 + b2F2 ... bkFk + εp The sensitivities (bk) are then used to predict the return the portfolio should provide for given values of the systematic risk factors; a higher positive sensitivity indicates greater positive exposure to a specified factor and higher expected return, holding all else equal. The factors (F) represent values that are related to security values, such as interest rates. For example, interest rates may be inversely related to security prices. If interest rates unexpectedly rise, then security returns will fall by the amount determined by the security's sensitivity (bk) to interest rate changes.

5. Index Weighting Schemes: Advantages and Disadvantages 5.4. Fundamental-Weighted Indexes Disdvantage

Fifth, just because fundamental-weighted indexes have outperformed capitalization-weighted indexes in certain past time periods does not mean they will in the future and, more importantly, does not indicate that they are useful indexes. As a reflection of "how the market did," an index should be judged on whether it is a representative sample, not on its performance. It is active management that is intended to deliver superior performance, not indexes. Index performance should be an outcome of index construction, not an objective. Furthermore, the reason why fundamental-weighted indexes have outperformed historically is that they are usually tilted toward small-cap value stocks, a well-documented effect in academic literature. For investors preferring a large-cap or growth emphasis, fundamental-weighted indexes would not serve as ideal benchmarks.

5. Index Weighting Schemes: Advantages and Disadvantages 5.4. Fundamental-Weighted Indexes Disdvantage

Fourth, the construction methodology used by these indexes is usually proprietary because they are created to market a fundamental-weighted fund. In this case, these indexes would not serve as valid benchmarks because their composition and weightings are not fully known.

Define index weighting There are several weighting schemes commonly used: 2. Equal weighting

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. The Value Line Composite Average is an equally weighted average of US stock returns.

5.6. Market Indexes as Benchmarks

From our previous discussion, we concluded that if a market index is to be used as a benchmark, a capitalization-weighted, float-adjusted index would likely be the best benchmark for most managers. Established indexes of that type are widely available, commonly accepted, and readily understood. In terms of the Bailey, Richards, and Tierney (2007) tests of benchmark validity, these market indexes generally fulfill most criteria because they are easily measurable, unambiguous, specified in advance, and generally investable. Most managers would also be familiar with and have an opinion on index securities. Plan sponsors may find market indexes acceptable as benchmarks if their managers select from the same universe of securities as the indexes and have no obvious style biases. However, capitalization-weighted, float-adjusted indexes may have several limitations for use as benchmarks. First, a value-weighted approach might not be compatible with a manager's investment approach. For example, as noted, value weighting may lead to concentration in large issues. Second, some construction rules might be less transparent than desired. As an example, consider float adjustment. Although desirable, some index providers do not fully disclose their adjustment process, and there is also no standardization of the process among providers. Moreover, as an index is reconstituted, its composition changes over time, sometimes in non-predictable ways. As a result, an index's style, sector, and risk exposures can change drastically over time.17

2. Distinguishing between a Benchmark and a Market Index Benchmark

However, many active managers follow specific investment disciplines that CANNOT BE ADEQUATELY DESCRIBED BY A SECURITY MARKET INDEX. BENCHMARKS must be appropriate for the SPECIFIC INVESTOR (SPONSOR) and any investment manager hired to manage money, whereas MARKET INDEXES are typically meant to serve the GENERAL PUBLIC'S PURPOSES and TO HAVE BROAD APPEAL VALID BENCHMARKS will be UNAMBIGUOUS, INVESTABLE, MEASURABLE, APPROPRIATE, REFLECTIVE OF CURRENT INVESTMENT OPINIONS, SPECIFIED IN ADVANCE, AND ACCOUNTABLE ("OWNED").

5. Index Weighting Schemes: Advantages and Disadvantages 5.3. Equal-Weighted Indexes Disadvantages

However, some argue that this type of weighting results in a small-issuer bias, the primary disadvantage of equal-weighted indexes, because small issuers are weighted the same as large ones. Second, to maintain equal weighting, strong-performing issues must be sold and weak performers must be bought, resulting in frequent rebalancing and high transaction costs for a portfolio tracking such an index. Third, the inclusion of small issuers means that investors tracking the index may not be able to find liquidity in some of these issues.

4. identification and evaluation of the current portfolio's risk exposures;

IDENTIFY & EVALUATE the RISK EXPOSURES of the MANAGER. Managers often describe themselves as "VALUE MANAGERS" or "GROWTH MANAGERS." However, these terms are imprecise. An appropriate benchmark will have RISK SIMILAR to the portfolio and be informative in revealing the manager's active risk exposures, which should help explain the manager's performance within his or her chosen investment style.

4.2. Index Construction

INDEXES are created by defining a SET OF RULES, which are then applied to a set of existing securities However, not all indexes are constructed in the same way. There are THREE primary choices in index construction: 1. INCLUSION CRITERIA 2. SECURITY WEIGHTING 3. INDEX MAINTENANCE

Completeness vs. investability

In principle, striving for complete coverage of a market would suggest including every possible security in the investment universe available to investors. Doing so, however, would include many small-capitalization securities that are too illiquid and could not be purchased in amounts relevant to institutional investors. Eliminating hard-to-trade securities improves the investability of an index. Index designers must decide how broad their indexes can be while maintaining adequate investability. As an example, the Wilshire 5000 is the broadest US equity index, representing more than 5,000 stocks. However, many of its stocks are illiquid and would be costly or very difficult to trade. As a result, no fund has ever tried to replicate the full sample of its securities. When index funds were created to track the Wilshire 5000, about 2,000 of its securities were untradeable. Indeed, one test of the investability of an index is to what extent there are investment funds that fully replicate it. Investability is not, however, the same as liquidity, as emerging markets sometimes illustrate. A security may have excellent liquidity in its home country but may not be investable for foreign investors if the country's government imposes restrictions. An index representing investment opportunities to developed-world investors should exclude non-tradeable emerging securities, reflecting the free float of the market from a foreign investor's perspective. Completeness and investability are important when indexes are used as a basis for investment vehicles. In choosing an index, the fund creator should consider how the index has balanced the tradeoff between completeness and investability. A more complete index can provide broader, more diversified performance.14 However, investability is an important concern for managers facing frequent and uncertain withdrawals. If investors suddenly withdraw funds, portfolio managers must quickly sell securities at possibly low prices. Another consideration is that portfolios tracking more popular indexes tend to have lower trading costs, owing to their greater liquidity.

Liability Based Benchmark Conclusion

In sum, in a liability-based benchmark, the benchmark is structured to accurately reflect the return required to meet the future obligations as well as mimic the volatility of the liabilities. As an additional benefit, MODELING THE LIABILITY risk exposure will help the portfolio manager better understand the liabilities that must be satisfied. In conclusion, the fund sponsor may select from a number of benchmarks, including BROAD market indexes. We next examine the uses of indexes.

5.6. Market Indexes as Benchmarks

In terms of the Bailey, et al. benchmark validity criteria, a market index will not be appropriate as a benchmark if the manager's style differs from the index's style. In this case, managers should not and likely would not be willing to be held accountable to the index. This shortcoming of market indexes as benchmarks reflects the fact that market indexes are designed to be representative of a market segment, not a particular manager's portfolio. The performance of a broad market index is usually influenced by many factors, few of which would be related to a manager's style or skill. A capitalization-weighted index is usually only valid as a benchmark when the manager takes a market-oriented approach or specifically tracks the index. In summary, market indexes are similar to Swiss Army knives; they serve many useful purposes but are sometimes not the best tool for the job.18 If market indexes do not capture a manager's investment process, a custom benchmark is often constructed, an example of which we examine in the next section.

Define index weighting There are several weighting schemes commonly used: 2. Price weighting

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. The most notable price-weighted indexes are the Dow Jones Averages, which are widely quoted and have a long history. The Nikkei Stock Average is also a price-weighted index, representing stocks listed on the Tokyo Stock Exchange

Basis for investment vehicles

Indexes are also used as a basis for investments, such as index mutual funds, many exchange-traded funds (ETFs), and derivatives. Index funds, ETFs, and derivative instruments are created on the basis of indexes ranging in breadth from broad markets to narrow market segments and investment themes. The royalties from licensing indexes for such uses has been a major driver of the proliferation of market indexes. Derivative instruments, such as futures and options, are used in hedging, trading, and asset reallocation and have other uses as well. More recently, indexes have served as the basis for ETFs. There is a great deal of research suggesting that it is difficult for active managers to earn their fees, so passive investments in low-cost index funds have become increasingly popular. There are also enhanced-index managers, who take active bets away from the index while also trying to limit their deviation from the index's risk. For an index to be useful as the basis for an investment vehicle, it must be one that an investor can replicate at low cost without much difficulty. In sum, indexes serve many vital purposes for sponsors, managers, and investors at large. We next examine the construction of indexes.

Performance benchmarks

Indexes are often used as ex post performance benchmarks, where they answer the basic question, did the manager beat the market? With the development of the capital asset pricing model (CAPM) in the 1960s, the "market" index return representing the entirety of assets became important in investment theory. Investment practitioners subsequently looked to various indexes as proxies of this "market" return. The same benchmark validity criteria apply. Sometimes, a combination of more than one index is used to create a benchmark for the manager, under the assumption that the manager's portfolio cannot be captured by a single index.

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. Examples: Insurance companies & defined benefit pension schemes. Investing assets using a liability-relative approach, assets are chosen for their ability to fund the payment of liabilities with relatively low risk. An appropriate benchmark for such an investor must accurately represent changes in the value of the LIABILITY stream and thus be LIABILITY-based.

4. style indexes;

Market indexes have also been more narrowly defined to represent investment styles within asset classes, resulting in style indexes. (An investment style can be defined as a natural grouping of investment disciplines that has some predictive power in explaining the future dispersion of returns across portfolios.)8 In the late 1970s, researchers found that stock valuation (e.g., defined using the price-to-earnings ratio) and market capitalization explained much of stock return variation. In response, many index providers provided various style versions of their broad market indexes. For example, in 1999, Wilshire introduced value, growth, and size subsets of its US Wilshire 5000 Index.9 Style indexes are formed under the belief that a characteristic of an asset, such as a stock's dividend yield or a bond's credit rating, will be the primary determinant of its subsequent performance.

Gauge of market sentiment

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? Index values are cited incessantly in business media as an indicator of daily (and even intra-day) market movements. Such movements are influenced by a wide variety of factors, such as the prospects for economic expansion or recession, war and rumors of war, and general feelings of investor confidence. Market indexes provide a convenient summary statistic of expectations because they are succinctly summarized in a single number, the current return on the index. Market indexes convey the perceived importance of both past events and the probability of future events. As a specific example of the latter, the Chicago Board Options Exchange (CBOE) Market Volatility Index (VIX) is a frequently used measure of market uncertainty.

4.3. Index Construction Tradeoffs

Previously, we said that indexes are widely used to represent the performance of asset classes and the "MARKET" in general. They are also INCREASINGLY USED as a basis for INVESTMENT vehicles. To satisfy these usages, index construction requires many choices, with accompanying tradeoffs. We examine these tradeoffs following the discussion in Siegel (2003).

6. returns-based (Sharpe style analysis) benchmarks;

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. The difference between the use of the style indexes previously discussed and returns-based benchmarks is that the latter view style on a continuum; for example, a portfolio may be characterized as 60% small-cap value and 40% small-cap growth. To create a returns-based benchmark using Sharpe style analysis, an optimization procedure is used in which the portfolio's sensitivities (analogous to the bk's in factor-model-based benchmarks) are forced to be non-negative and sum to 1

1. Reference points for segments of the sponsor's portfolio;

SPONSOR benchmarks need to be distinguished from FUND MANAGER benchmarks. A sponsor's SAA (policy portfolio) is the LONG-RUN allocation to asset classes consistent with the sponsor's objectives and constraints. From this, a benchmark, often in the form of an investable MARKET INDEX, will be specified for each asset class in the SAA. That practice implicitly and reasonably specifies a PASSIVE investment in the asset class as a NEUTRAL comparison point in measuring SPONSOR PROGRESS TOWARD INVESTMENT GOALS By doing so, benchmarks are useful as reference points for segments of the sponsor's portfolio.

5. Index Weighting Schemes: Advantages and Disadvantages 5.1. Capitalization-Weighted Indexes Advantages (2)

Second, a capitalization-weighted, float-adjusted index is the only index type that all investors could hold. If all investors held all the securities in cap-weighted indexes in proportion to their market value, then all shares would be held, with none left over. This property has been referred to as macro consistency (Siegel 2003). With other weighting methods, such as fundamental-weighted indexes, not all investors could hold the index. A cap-weighted index is thus the best representation of a typical investor's opportunity set. As a result, a capitalization-weighted index is superior at succinctly representing the effect of changes in a market's total value and investors' total wealth. This property is closely related to one of the central results of the original capital asset pricing model (CAPM): Under the assumptions of the CAPM, a cap-weighted portfolio of all assets is efficient, and all investors in a CAPM world would hold a proportional investment in the market portfolio. A cap-weighted index reflects this concept.

Objective and transparent rules vs. judgment

Security prices rise when securities are added to an index and fall when they are deleted from an index. Index reconstitution results in decreased returns for managers tracking the index because they have to buy added securities at higher prices and sell deleted securities at lower prices. These price changes will be more acute for more popular indexes. Transparency and objectivity are desirable characteristics of indexes because they allow investors to readily predict the changes in index constituents that might occur. This information enables investors to anticipate changes and trade accordingly, instead of reacting to them. Less transparency and the greater use of judgment by the index provider make it harder for investors to determine the constituents of an index and anticipate changes in it, making the index less investable and creating additional costs for tracking portfolios. All index constructors, however, exercise some degree of judgment in applying their methodologies. Doing so allows providers to adapt to changing circumstances or special situations that might not have been anticipated by explicit rules. Some providers intentionally use committees to choose index constituents, for example, in order to obtain certain characteristics that might be difficult to describe in rules. Index designers must decide when to use judgment in their methodologies and how much to use. In sum, there are many choices and steps in index construction. An index provider must define the universe of eligible securities, determine the index weighting, and maintain the index. From an index user's perspective, an index should be constructed using simple, transparent methods that are replicable. The index creator should publish clear, unambiguous construction rules, and the data should be available in a timely manner. We next examine the advantages and disadvantages of index weighting schemes in more detail.

5. Index Weighting Schemes: Advantages and Disadvantages 5.2. Price-Weighted Indexes Disadvantages

There are several disadvantages of price-weighted indexes. First, price-weighted indexes are overly influenced by the highest-priced securities because they have greater weights in the calculation of the indexes' returns.16 Because price-weighted indexes weight by price instead of total market value, they do not necessarily reflect the economic importance of issuing companies. Second, stocks that appreciate often experience stock splits, and their weights in the index will decrease. Successful companies will become underrepresented, creating a downward bias in the index return. Lastly, price-weighted indexes assume an investor holds one unit of each security in the index, which does not describe how most investors form portfolios.

5. Index Weighting Schemes: Advantages and Disadvantages 5.2. Price-Weighted Indexes Advantages

The main advantage of price-weighted indexes lies in the simplicity of their construction. Price-weighted indexes also have a long historical track record, which facilitates investment research. For example, the DJIA was first published in 1896.

Define index weighting There are several weighting schemes commonly used: 1. Capitalization weighting, 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. There are several advantages to this approach, which are discussed later. Examples of US capitalization-weighted indexes include the S&P 500 and the Russell indexes. Global indexes that are capitalization weighted include the MSCI indexes. Non-US indexes include the Financial Times Actuaries Share Indexes (representing stocks on the London Stock Exchange), the Tokyo Stock Exchange Price Index (TOPIX), the CAC 40 in France, and the DAX 30 in Germany. Nearly all capitalization-weighted indexes are adjusted for the free float. The free float is the amount of shares outstanding for a given company that is available to the public. This adjustment is intended to exclude the capitalization of a company that is not widely available for purchase and thus is not part of the investable opportunity set. The resulting index is called a free-float-adjusted market capitalization index, or float-weighted index for short. A float-weighted index represents the performance of a portfolio that holds all the index securities available for trading. Adjustments for free float are particularly important in less developed markets, where governments, founding families, and other companies often hold a large portion of issued stock. All the major global indexes are float adjusted, including those of S&P Dow Jones Global, FTSE, MSCI, Russell, and S&P/Citigroup.12 Float adjustments result in the index being more investable.

5. Index Weighting Schemes: Advantages and Disadvantages 5.3. Equal-Weighted Indexes Advantages

The primary advantage of equal-weighted indexes is that they give smaller weights to large-cap securities (and larger weights to small-cap securities) than indexes formed by cap weighting. By reducing exposures to the largest-cap securities, the index is thereby less concentrated in those securities and more diversified. Proponents of this approach suggest that market prices do not always reflect true value and that equal weights reflect a more naive or informationless weighting of a portfolio, resulting in superior returns during particular historical periods. Second, these indexes may better represent "how the market did" because they provide an average of all index security returns.

Reconstitution and rebalancing frequency vs. turnover

The processes of reconstitution and rebalancing are designed to keep an index close to its intended membership and weighting criteria. Reconstitution refers to the process of adding and dropping securities from an index, whereas rebalancing refers to a readjustment in the weights of existing securities. In principle, more frequent reconstitution and rebalancing would be desirable in order to improve representativeness were it not for the fact that such activities create turnover in the index. Turnover is costly for investors who wish to track an index because they must trade more often. Therefore, there is a conflict between representativeness and low turnover. Index designers must decide how often to reconstitute and rebalance their indexes while maintaining tolerable turnover. Turnover is a potential concern for managers who track particular size and style indexes because they must trade as companies migrate from one classification to another. As a result, these indexes are less frequently reconstituted by providers. In contrast, the turnover in broad market indexes typically occurs among smaller issues, resulting in less trading when the index is reconstituted. Reconstitution is also less frequent for all-inclusive indexes than for those with a fixed number of securities (e.g., the S&P 500), where securities periodically enter and exit the index. Rebalancing is of particular concern in international indexes, where float adjustments are more important. At one extreme, index creators could frequently adjust the float of index constituents to precise amounts. This adjustment would result in frequent rebalancing and high transaction costs for tracking portfolios. Instead, many index providers use bands to make float adjustments, where a range is used to capture the percentage of the issue's market cap that is free floating (e.g., 60%-70%). As long as the issue's estimated free float stays within the band, they do not adjust the issue's weight in the index. A narrower band would result in more frequent rebalancing.

5. Index Weighting Schemes: Advantages and Disadvantages 5.4. Fundamental-Weighted Indexes Advantages

The proponents of fundamental-weighted indexes argue that capitalization-weighted indexes overweight overvalued issues and underweight undervalued issues. Fundamental-weighted indexes seek to avoid this problem by using valuation metrics, rather than market value, to weight index constituents. Proponents also assert that these indexes will be more representative of an issuer's importance in an economy because they weight by fundamentals, rather than by market prices subject to bubbles.

3.2. Types of Benchmarks

The seven types of benchmarks 1. absolute (including target) return benchmarks; 2. manager universes (peer groups); 3. broad market indexes; 4. style indexes; 5. factor-model-based benchmarks; 6. returns-based (Sharpe style analysis) benchmarks; 7. custom security-based (strategy) In addition, we discuss liability-based benchmarks which represent characteristics of a stream of liabilities rather than A MARKET or MARKET SEGMENT as do BROAD MARKET and STYLE INDEXES.

Define eligible securities

The starting universe of securities, such as all common equity shares of companies within a given country, must first be identified. Typically, various eligibility rules are applied to improve the investability of the index. Examples of eligibility rules include liquidity standards, minimum trading price, available shares (float), etc.

5. Index Weighting Schemes: Advantages and Disadvantages 5.1. Capitalization-Weighted Indexes Diadvantages

There are disadvantages of capitalization weighting however. First, because they are market value weighted, these indexes could be overly influenced by overpriced securities. As a security's price increases through time, its representation in the index will grow. The capitalization-weighted index is thus potentially more susceptible to market bubbles and will not necessarily represent an efficient investment from a risk-return perspective. Second, the index may be overly concentrated because large issues will be weighted the most heavily. For example, in 2013, the 10 largest constituents of the S&P 500 represented approximately 19% of its value.15 Some investors may prefer a more diversified portfolio. Similarly, active managers may desire weights that are different from those of the index, and institutional investors may not be able to track a capitalization-weighted index if they are subject to maximum holdings. Portfolio risk and return for these managers may, therefore, substantially deviate from the index, meaning that the index will not serve as a valid benchmark.

3. Benchmark Uses and Types 3.1. Benchmarks: Investment Uses b. describe investment uses of benchmarks;

There are several uses of benchmarks in investment practice, including the following: 1. reference points for segments of the sponsor's portfolio; 2. communication of instructions to the manager; 3. communication of instructions to a board of directors (or any oversight group) and consultants; 4. identification and evaluation of the current portfolio's risk exposures; 5. interpretation of past performance and performance attribution; 6. manager appraisal and selection; 7. marketing of investment products; and 8. demonstration of compliance with regulations, laws, or standards.

2. communication of instructions to the manager;

They will convey the sponsor's expectations to the manager as to how the fund assets will be invested and their expected risk and return. By conveying the sponsor's expectations, BENCHMARKS PROVIDE accountability, so that if a manager's security selection and subsequent performance frequently diverges far from the benchmark, it is apparent that the manager's investment approach is inconsistent with the fund's stated investment discipline. Benchmarks ALSO ENSURE A DEGREE OF FAIRNESS in the sense that the MANAGER will not be held to STANDARDS that the fund's BOARD or consultants might arbitrarily IMPOSE.

5. Index Weighting Schemes: Advantages and Disadvantages 5.1. Capitalization-Weighted Indexes Advantages (3)

Third, a capitalization-weighted index requires less rebalancing than other indexes. In value weighting, changes in prices do not create a need to add or remove shares; the index remains cap weighted after a change in price. The capitalization-weighted index also self-corrects for stock splits because they are reflected in the number of shares outstanding and price per share. If an investor tracks a capitalization-weighted index and there are no changes in the index constituents, then the portfolio will automatically track the index and no rebalancing is necessary. Other weighting schemes require periodic trades to bring the weights back to those required by the scheme.

5. Index Weighting Schemes: Advantages and Disadvantages 5.4. Fundamental-Weighted Indexes Disdvantage

Third, as mentioned previously, not all investors could hold a fundamental-weighted index because they are weighted by valuation metrics, not by available liquidity (market capitalization).

Define index weighting There are several weighting schemes commonly used: 2. Fundamental weighting

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.

Asset allocation proxies

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.

4. Market Indexes Uses and Construction 4.1. Use of Market Indexes

We discuss the uses of indexes in the approximate order that a PLAN SPONSOR would encounter them in practice: 1. as asset allocation proxies 2. investment management mandates 3. performance benchmarks 4. portfolio analysis applications Additionally, we discuss the use of indexes as a gauge of market sentiment and as the basis for investment vehicles.

The SECOND CHOICE, selecting the methodology for security weighting,

is usually a choice among value, price, or another weighting scheme. Indexes vary in their weighting schemes, resulting in performance differences among indexes.