Guide to Equity Index Construction, A

Publication Date	April 2007
Publisher	Risk Books
Product Type	Book
Pages	406
ISBN Number	not applicable
Product Code	RIS00367

Price

£99.00
approximately: $175 | €126

PRINT £99 ($175 | €126)

Order above formats by FAX

Summary

Equity indexes out-perform the majority of active fund management strategies. Not only will this book teach the reader to construct an optimal index, but it will also assist fund managers to 'know their enemy'.

Index construction is an important scientific process. There are now estimated to be €14 trillion of equities under professional management, and theory suggests that these funds should have an appropriate benchmark in order to match assets and liabilities.

A Guide to Equity Index Construction presents readers with an independent explanation of the processes of methodical index construction. It also addresses the inefficiencies in the construction process that could potentially be exploited by active managers, or those wishing to refine the process, in order to create better indexes in the future.

Documenting best practice and keeping mathematical formulae to a minimum, this guide provides a straightforward set of rules and all the tools and techniques you will need to construct an equity index.

With over 20 years experience in the fund management industry, author Daniel Broby, presents a clear and workable methodology and:

equips you with the skills to construct an optimal index;
debates the issue of an appropriate benchmark for equity funds;
shows the link between the CAPM and index construction;
helps you to understand the nature of the underlying return series;
makes better fund managers out of active managers through an improved understanding of benchmark construction;
enables you to differentiate between the myriad of derivative and synthetic ways to gain exposure to an index.

This powerful reference manual is recommended for fund managers, index constructors, quantitative analysts, risk analysts, CIOs, institutional relationship managers, financial journalists, finance students and academics.

Content

Introduction
1. The Index and Modern Portfolio Theory Introduction
- Defining the terms benchmark and index
- Defining efficiency
- Background
- A brief history of equity indexes
- Capital asset pricing model.
- The three-factor model
- This book is focused on the practical
- The way forward
- Conclusion
2. Which benchmark?
- Introduction
- Levelling the playing field
- Capturing "systematic" returns
- Choosing between arithmetic and geometric approaches
- Benchmark methodology: total capitalisation method
- Benchmark methodology: price-weighted method
- Benchmark methodology: equal weighted method
- Should the benchmark adjust for "free float"
- The importance of brand
- Case Study: choosing a benchmark index for the Norwegian Petroleum Fund's equity investments
- Conclusion
3. Taking risk into account
- Introduction
- Volatility and variance as risk proxies
- Background
- Risk and the efficient frontier
- Being careful not to take on too much beta
- Avoiding alpha risk
- over-reliance on the index
- No garden is without weeds
- Risk is a function of the economy
- The equity risk premium
- Other risk considerations
- Case study: What risk premium is normal?
- Conclusion
4. The efficiency of the Benchmark index
- Introduction
- Efficiency as a moving target
- Efficiency and the economy
- Pricing efficiency
- Operational efficiency
- The benchmark as a proxy for the market portfolio
- Issues with achieving a pure market proxy
- Free float and index efficiency
- Roll's critique of the use of a benchmark
- Testing benchmark efficiency
- What if fund managers outperform the index?
- Tracking error as a measure of efficiency
- Active share as a measure of efficiency
- The candidate index problem
- Case study: The S&P500 - the investor's choice of benchmark proxy
- Conclusion
5. Sampling and selection procedures
- Introduction
- Construction methodology
- Advanced estimation techniques
- The starting point - the base date
- The zero-one integer problem
- The index divisor
- Estimating the key characteristics
- Creating rules
- Random sampling
- Stratified sampling
- Apportioning stock weights and the depth of an index
- Number of stocks in an index
- Size of company in the index
- Fixed-share capitalisation indexes
- Determining the free float adjustment
- Provisional indexes
- Which countries to include
- Which industries to include
- Volume considerations
- Fundamental ratios
- Short positions
- Case study: The MSCI and S&P-IFCI treatment of Korea and Taiwan
- Conclusion
6. Establishing statistical method
- Introduction
- Descriptive statistics
- Correlations
- Cluster analysis
- Tables and graphs
- Creating a matrix
- Simple aggregate unweighted index
- Arithmetic Indexes
- Geometric Indexes
- Which methodology to use - arithmetic or geometric?
- Unbiased averages
- The Laspeyres index
- Paasche index
- Fisher index
- Marshall-Edgeworth index
- Tornqvist index
- Carli elementary price index
- Dutot elementary price index
- Jevons elementary price index
- Chain linking
- Backtesting
- Potential Bias
- Case study: The FTSE Mediterranean 100
- Conclusion
7. Making the index investable
- Introduction
- The key determinants of investability
- Trading costs' impact on investability
- Market impact
- Bid-ask spread
- The impact of futures and options on investability
- Rising liquidity
- Privatisations and new issues
- What size is investable?
- Length and timing of trading
- Size capitalisation and investability
- Free float and investability
- Client investability requirements
- Case study: Bulgaria - an illiquid emerging market
- Conclusion
8. Collection and Processing of Data
- Introduction
- Clean data
- Data preparation
- Data requirements
- Static data
- Dynamic data
- Building the database
- Common errors
- Public information
- Common aggregating services
- Direct exchange price feeds
- Corporate actions
- Coping with data volatility
- Issuer name
- Description
- ISIN
- CUSIP
- SEDOL
- ISO
- Survivorship bias
- Case study: Establishing a historic data series in France
- Conclusion
9. How to Handle Industries
- Introduction
- What is an industry?
- Standard Industrial Classification
- Global Industry Classification Standard
- Industry Classification Benchmark
- Fama and French Industrial classification
- Industrial change
- Herfindahl index
- Creating a sector-neutral index
- Consumer-goods industry - non-cyclical
- Consumer goods industry - cyclical
- Healthcare
- Financial sector
- Technology
- Basic industrial sectors
- Basic equipment industry
- Telecommunication services
- Utility services
- Changing industry
- Case study: A specialist sub index - the Macquarie Global Infrastructure Index (MGII)
- Conclusion
10. How to Handle Factor Exposure
- Introduction
- The arbitrage pricing model
- Should factors be used in benchmark construction?
- Single or multiple factors
- Economic factors
- Fundamental factors
- Country and sector factors
- Growth and value factors
- Non-linear-style probability
- Size factors
- Interest rate factors
- Country factor exposure
- Integration, covariation and correlation
- Conditional versus unconditional models
- Undertaking factor analysis
- The P8 portfolio test
- Case study: A style index - S&P500/Citigroup Value Index
- Conclusion
11. How to Handle Countries and Currencies
- Introduction
- Countries and the CAPM
- International CAPM
- Domicile
- National history
- Home country bias
- National industry clustering
- Increasing integration
- Time zone
- Defining developed markets
- Defining emerging markets
- Multi-currency indexes
- The major currencies
- The minor currencies
- Overcoming cross-border capitalisation bias
- EAFE
- Supranational constraints
- Foreign ownership limits
- Dual listings
- Case study: The MSCI World
- Conclusion
12. Maintenance
- Introduction
- Rebalancing frequency
- Downward-sloping demand-curve hypothesis
- Liquidity hypothesis
- Information content hypothesis
- How radical should changes be?
- Turnover
- Avoiding bias
- Applying optimisation techniques
- Index committee
- Removing companies
- Takeovers
- Financial operating failure
- Initial public offerings
- Correlation breakdown
- Silent indexes
- System design
- Case study: FTSE Policy Group and Equity Indexes Committee
- Conclusion
13. The Commercial indexes
- Introduction
- Competitive dynamics
- Differences in construction
- The S&P/Citigroup equity index
- Case Study: Differences in European indexes
- Conclusion
14. Bespoke indexes
- Introduction
- Reasons for adopting a custom index
- Users of custom indices
- The politics of forming a new bespoke index
- Multinational indices
- ADR or synthetic equity indexes
- Tax adjusted
- Case study: Differing approaches to Socially responsible Investing
- Indexes on Bloomberg
- Using Bloomberg to build a custom index
- Conclusion
15. Tying it all together
- Introduction
- The key lessons
- Important characteristics of good indexes
- Practical application of the lessons learnt
- Investors as users of indexes
- Areas for further consideration
References