Benchmark selection is critical. This has recently been the focus of more attention by the marketpla...
Benchmark selection is critical. This has recently been the focus of more attention by the marketplace than ever before, as pension funds and their advisors are beginning to realise the importance of benchmark selection. The reason why it is so important is really very simple. When companies are omitted from a benchmark portfolio or when they are included at the wrong weight, the return of the benchmark changes. While these changes are important for funds who use passive management techniques, they are also important for those who use active managers as they are setting the target for those managers to beat, and in so doing they will affect the way in which that manager manages the money.
What are we trying to do, then, when we use a benchmark? Simply to measure the opportunity set, that is, everything that the investor can buy and nothing they can't. It seems obvious that this is what should be measured. In fact, if we reverse this statement it becomes even more obvious. If we disagree with this definition of the opportunity set, it must be either because we believe that we should be omitting stocks that the investor could purchase, or alternatively measuring stocks that could not be bought by the investor.
Either of these propositions appears a little challenging!
So, what we need to ensure is clearly these two factors. How can we measure them for a particular index series using simple data?
The first step is to ensure that everything that should be included is included. Let's call this coverage. What is meant by this is simple: what proportion of the actual available capitalisation in the market is represented in the index? Ideally this should be 100%. If an index has a coverage figure of less than 100%, then available capital is not being represented, or as described above we are not measuring everything we could possibly buy.
The calculation of the coverage figure is very simple:
Coverage = Index Available Capitalisation/Market Available Capitalisation
Step two is to ensure that nothing that is not actually available in the marketplace is included. Let's call this accuracy. It also has a very simple meaning: whether the index accurately measures the companies that it contains. This can be looked at another way. Accuracy simply reflects whether the stated capitalisation of the index is in fact the true available capitalisation of the index. If the stated capitalisation of the index is larger than the true available capitalisation then the accuracy will be less than 100%, because the index is measuring things which are not available to the investor.
The calculation of the accuracy figure is also very straightforward:
Accuracy = Index Available Capitalisation/Index Stated Total Capitalisation
We now have two tools, coverage and accuracy, which allow us to measure whether a particular index series is an appropriate one to use. So, how do some of the major indices used today measure up?
The results are somewhat surprising. This table compares four developed market indices. The MSCI and FTA series are familiar. The other two series are the Schroder Salomon Smith Barney (SSSB) Broad Market Index, the broadest all-cap index prepared by SSSB, and the SSSB Primary Market Index, the main large-cap index prepared by SSSB. A number of things jump out from this table. First, the SSSB BMI is the only index in the list to have both 100% coverage and 100% accuracy scores. It is designed to replicate the total opportunity set, and appears to do so. All of the other indices have lower coverage scores, although in some of these cases this is because they are attempting to cover only part of the market. An example is the SSSB PMI, which attempts to cover only large cap stocks, defined as the top 80% of the market. Two of the indices have accuracy rates of less than 100%. This is caused by the inclusion of unavailable capital in the index.
These indices are constructed using different methods, and may be used in different ways. The use of these two simple arithmetic tools, however, may help the pension fund understand these differences in a clear and intuitive way.
Ian Toner is vice president, Equity Index Group at Salomon Smith Barney
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