R19 - Market Indexes And Benchmarks

Question 1

Characteristics of a well-specified benchmark?

Answer 1

1. Specified in advance to manager and client
2. Appropriate to manager style and portfolio obj/constraints
3. Measurable
4. Unambiguous
5. Reflective of manager’s investment opinions
6. Accountable - client/manager agree on its use
7. Investable at low cost as alternative to active management

Question 2

Pros and cons of market cap weighted indexes?

Answer 2

+mkt cap is objective measure of value
+consistent with what is owned in aggregate
+efficient under CAPM assumptions
+no rebalancing for splits

• Greater exposure to overvalued stocks
• can be concentrated in some stocks
• not suited to some manager styles/portfolio objectives

Question 3

Pros and cons of price weighted index?

Answer 3

+easy to make
+long price histories exist

• price not reflective of economic importance
• successful stocks tend to split and thus lower weighting
• not how most portfolios are constructed

Question 4

Pros and cons of equal weighted index?

Answer 4

+emphasizes small cap stocks vs mkt cap weighted for return advantage and diversification
+better reflects average return of market
-disproportionate emphasis on small cap performance and less liquid stocks
-continual rebalancing required to maintain equal weight