Chapter 15: Investment indices Flashcards
Construction of indices
Weighted arithmetic indices
- Chain-linking
Total return indices
- XD adjustment
- Yield adjustment
Unweighted arithmetic indices
Geometric indices
Weights are often restricted to reflect the free float of shares available for purchase, thereby…
eliminating strategic holdings
Free float
The proportion of shares that’re freely available for purchase on the open market.
Chain-linking process is set up so that:
- the index reflects the new market capitalisation of the constituents
- the index value is not disturbed by the change in capital structure of its constituents
Aim of index: Reflect the investment performance of its constituents.
Circumstances in which chain-linking would be required
- rights issue or share buy-back by constituent company
- new issue of a share in the sector covered by the index (newly formed company, privatisation, demutualisation)
- merger, takeover or break-up involving constituent company or companies
- change in constituent companies in an index, resulting from a change in relative market capitalisations due to share price movements (e.g. 100th largest falls out of the index)
Holding period return
(P1+d)/P0 -1
- P0 and P1 are values of the investment at beginning and end of the period
- d is the income generated by the investment over the period
When do you assume the dividends are reinvested?
Usual assumption is to use the ex-dividend date. This may lead to problems if the index is used by index tracking funds, since the tracking funds will not be able to reinvest the dividends until actually received.
Unweighted arithmetic indices
AKA price weighted indices.
It is the arithmetic average of the relative price changes of the constituents.
Unsuitable as a benchmark for dynamic institutional portfolios.
Why are unweighted arithmetic indices unsuitable as a benchmark for dynamic institutional portfolios?
Because the performance of any investment portfolio will reflect the actual weights (i.e. market capitalisations) of the constituent investments held within that portfolio which are unlikely equal.
Merits of an unweighted geometric index
- Easy to calculate (only need price data)
- Gives an indication of short-term price movements
- Unsuitable as a benchmark for an investment strategy or portfolio investment measurement (if one price goes to zero, the whole index does)
- Constituents need to be changed to avoid this happening
The uses to which indices can be put
FINDS Best Hidden Spots
- Future movements (tool for estimating based on past trends)
- Index funds (basis for these funds)
- Notional portfolio (valuing it)
- Derivatives -basis for the creation relating to market or sub-sector of market
- Sub-sector analysis
- Short-term market movements (measure)
- History of market movements and levels given
- Benchmark against which to assess investment performance of portfolios
+SAGS (for government bond indices)
- Standard - to compare yields from other fixed interest investments
- Approximate - valuation of fixed interest portfolios
- Gap (yield gap between bonds and equities)
- Structures - picture of general yield structures of fixed interest investments
Relevance of indices
- investor’s investment objectives specified with reference to one or more indices
- used in development of appropriate portfolio to best achieve those investment objectives
- used to value the portfolio and provide benchmark for performance monitoring
Factors to consider when specifying/creating/using an index
- purpose of index
- constituents and basis for inclusion/exclusion
- type of index (e.g. weighted arithmetic)
- frequency of calculation
- price data to use (e.g. mid-market prices)
- how to deal with capital changes (e.g. chain-linking)
- what to do about income (e.g. XD adjustments, total return indices), how to deal with tax, when to credit income, when to reinvest, etc.
Index fit for purpose
When an index is used to model a real world situation, important to ensure the constituents of the index are good match for the real world situation being modelled.
UK Equity Indices
FTSE UK Index Series
Market capitalisation weighted arithmetic indices. In addition to capital and total return index numbers they give:
- Average net dividend cover
- Actual dividend yield
- Price earnings ratio
- Ex-dividend adjustment
Specific Indices:
- FTSE 100 Index
- FTSE 250 Index
- FTSE 350 Supersectors Indexes
- FTSE SmallCap Index
- FTSE All-Share Index
- FTSE Fledgling Index
- FTSE AIM Index Series
US equity indices
- Dow Jones - unweighted index
- Standard and Poor’s (S&P 500) - weighted arithmetic index
- NASDAQ
Equity indices for Japan
- Nikkei - arithmetic index
- Topix - market capitalisation arithmetic index reflecting free float (more comprehensive and suitable for performance measurement than Nikkei)
Equity indices for Europe
- DAX (Germany) - real-time total return index
- CAC (France) - CAC 40 vehicle for an index futures contract
- FTSE Eurotop 100
- FTSEurofirst 300
- Eurobloc equivalents
- Dow Jones Eurostoxx 50
Volatility indices
Used as an indication of market’s perception of risk
VIX
- weighted average of prices for a range of 30-day expiry put and call options on the S&P 500 index.
- Level of the index, which is quoted in annualised percentage terms, is the risk neutral expectation of the volatility on the S&P 500 index over a 30 day period
Equity indices for South Africa
FTSE/JSE Africa Index Series replaced JSE Actuaries - indices free float adjusted (based on market capitalisation previously)
FTSE/JSE Africa Headline indices comprising:
- FTSE/JSE ALSI (All Share Index)
- TOP 40
- Mid-cap index
- Small cap index
- Fledgling Index
Other indices published by JSE include:
- Sector and Sub-Sector Indices (FTSE Classification System)
- Secondary Market Indices - Development Capital, Venture Capital, Alternative Index
- Specialist Indices - SWIX (adjusted for foreign shareholding), Style Indices (published indices include Growth and Value), RAFI All-Share Index (weighted by fundamental factors - sales, cashflow, book value and dividends)
Total Return Indices published end of each working day and are based on ex dividend adjustments.
International indices
- FTSE Global Equity Index series
- The FTSE Global Climate Index series
- Morgan Stanley Capital International indices
FTSE Global Equity Index series attempts to overcome
Indices in some markets that may not be:
- sufficiently comprehensive
- calculated consistently
- calculated accurately.
FTSE Global Equity Index series construction
- captures around 98% of the world’s equity markets in terms of investible market capitalisation.
- divided into developed, advanced emerging and secondary emerging segments.
- stocks not available to foreign investors are not included in the index
- weighted arithmetic indices – weightings free float
FTSE Global Equity Index series coverage
- shown for each country in US dollar & local currency terms
- local currency index gives measure of underlying performance of market
- dollar currency index shows performance adjusted for movements in the currency concerned
- indices in respect of market type and region
- indices include dividend yield and total returns index for each country
FTSE Global Equity Index series uses
- Performance measurement for international investments
- Help research into the relative merits of investing in different countries
Advantages of FTSE Global Equity Indices
- consistency between countries
- easier to obtain than some local indices
- more suitable for performance measurement of international investments than local indices
The FTSE Global Climate Index series
Designed to reflect performance of global and diversified basket of securities
Weights varied based on three types of climate related analysis:
- carbon emissions
- fossil fuel reserves
- green revenues data
Incorporates both risks and opportunities associated with climate change and transition to a green economy
Morgan Stanley Capital International indices
Widely used series of international equity indices covering developed and emerging markets.
- calculated on market capitalisation weighted arithmetic basis
- total returns published gross and net of witholding tax
MSCI ACWI - free float adjusted market capitalisation weighted index
Fixed income indices
- FTSE Glits Index series
- FTSE Global Bond Index series
- Markit iBoxx fixed income indices
- Credit derivative indices
- South African bond indices
FTSE Glits Index series
Series covers conventional and index-linked glits.
Price, total return and yield indices are published, with indices subdivided according to term.
Index number are calculated using dirty prices (inclusive of accrued interest)
Price and total return indices
- market capitalisation weighted arithmetic indices, dirty prices being used
- indices are chain-linked to allow for new issues, redemptions and movements of stocks between categories
UK yield indices
- conventional gilts: yield index is constructed by fitting a curve to the gross redemption yields of stocks in the particular category
- irredeemable stocks are included in each coupon band to give stability to long end of curves
- optional redemption dates - date used which gives lowest redemption yield
- index-linked gilts: each yield index represents avergae yield of the stocks in that category
FTSE Global Bond Index series
What are the homogenously constructed bond families in the series?
Covering principal bond markets, including, France, Germany, US and Japan and global emerging markets. Series comprises 4 homogenously constructed bond families:
- FTSE Global Government Bond indices - central government debt denominated in domestic currency. Sub-indices are segmented by maturity
- FTSE Covered Bond indices consist of securitised issued
- FTSE Corporate Bond indices covering investment grade bonds from corporate entities. Sub-indices available by maturity band, indistry group and credit rating
- FTSE Euro Emerging markets Bond indices - Euro denominated government bonds from emerging countries
Markitt iBoxx fixed income indices
What are the 6 categories of the investment grade bond issues?
- cover Euro, Sterling, Asian, US dollar and European High Yield bond markets & comprise investment grade bond issues in 6 categories:
- sovereigns
- sub-sovereigns
- collateralised
- corporates
- financials
- non-financials
- based on bid and ask bond prices supplied throughout trading day by leading investment banks
- consolidated bid and ask prices calculated from these and used for index calculation
Other international fixed income indices
- Bank of America, Merrill Lynch and JP Morgan produce indices covering many aspects of fixed income market, incl. inflation-linked and swaps indices.
- published as global/multicurrency and regional/single currency benchmarks
- large number standard sub-indices available
Credit derivative indices
Indices of credit default swaps (CDS)
- Corporate bond indices blend interest and credit risk
- CDS indices can be used by analysts and investors to monitor more directly the price of credit risk
- Cheaper to hedge CDSs/bonds with CDS index because it is standardised and more liquid than to buy many single name CDS to achieve similar effect.
iTraxx Europe Main
- Different index series are established every 6 months, and the constituents are top 125 names in terms of CDS volume traded in 6 months prior to this (rolling index)
- Unweighted average of CDS premium for constituents
- number of different sub-sector indices for different industries
CDX
Corresponding US indices of iTraxx Europe Main (Credit derivative indices)
South African bond indices - Fixed interest bond and inflation-linked bond indices
Main fixed-interest bond index – ALBI (All Bond Index) – composite index containing top 20 fixed interest bonds
- Ranked by liquidity and market capitalisation
- Split into GOVI (Government Bond Index) – top 10 government bonds issued – and OTHI (Other Bond Index)
CILI (Composite Inflation-Linked Index) - main index-linked bond index and split into:
- Government (IGOV)
- State owned enterprises (ISOE)
- Corporates (ICORP)
ALBI and CILI - clean price index, interest yield index and total return index (assumes coupons reinvested immediately after payment)
South African bond indices - Credit indices
Credit Indices produced by JSE for corporate bonds.
- Three indices include Credit Fixed, Credit Floating and Credit Composite.
- Credit composite Index – weighted average index of Credit Fixed and Credit Floating Indices
Money market instruments – Short Term Fixed Interest (SteFI) Composite Index is used.
- Benchmark index for cash equivalent investments and now calculated & published daily by South African Futures Exchange (SAFEX)
Constituents and weightings of AlBI changed in what circumstances?
- Bond weightings change monthly based on issuance during period
- Constituent changes are effected quarterly. Changes driven by changes in eligibility criteria or excluded if bonds fall below one year during next period
Problems when constructing indices of unlisted or illiquid assets
- Lack of reliable and up-to-date price data
- Heterogeneity of assets included
Problems in obtaining price data in frequent intervals for illiquid or unlisted asset indices
- Unique - not representative of sector/asset class overall
- Market value is only known for certain when the asset changes hands
- Subjective, expensive and time consuming estimation of value
- valuations may be carried out at different points in time, not necessarily st time the index is calculated
- infrequent sales of certain assets - interim values need to be estimated or determined by suitable valuation expert
- prices agreed between buyers and sellers are normally treated with a degree of confidentiality
Problems with using surveyors’ valuations as an alternative to actual sale prices (for property index creation):
- subjectivity
- cost
- circularity - indices based too heavily on supervisors views but surveyers form their views based on trends of the indices
Types of property indices
- Portfolio-based indices
- Barometer indices
Portfolio-based indices
- Measure rental values, capital values and total returns of actual rented properties
- Rates of return are money-weighted
- Underlying portfolios will vary according to size, regional spread, sector weighting (office, retail, etc), direct vs indirect, prime and non-prime, tenure(freehold or leasehold)
Merits of portfolio-based indices
- Current rental income is fixed until the next rent review - Sluggish response to movements in rental values
- Timing and magnitude of cashflows into a property will influence the results - because MWRR
- Mainly used for performance measurement
Barometer indices
Aims to track movements in the property market at large by estimating the maximum full rental values of a number of hypothetical rack-rented properties
Merits of barometer indices
- Subjective estimate (of rack rents) for hypothetical properties
- Thus, should give an earlier indicator of changes in market rent levels
- Unsuitable for portfolio performance measurement - (Investor unable to closely match with an actual portfolio)
- Highlight short-term changes in level of the market in terms of rents and yields
Property index providers
Divided into residential and commercial indices
Commercial indices further divided into industrial, office and retail categories
IPD is leading index provider for commercial property indices (used for pricing property derivative contracts)
Alternatives to property indices
Collective investment schemes investing in real property.
- May have issues surrounding regular valuation.
- A large scheme withwide range of investments may be trading and valuing sufficiently frequently to smooth out main difficulties
- Use published prices as a proxy for an index
Adjust prices for regular management or other charges.
- Many schemes invest significantly in property company shares and real property - distort results.
