Choosing your benchmark
A benchmark is an index, or a market measurement indicator, that is used to assess the risk and performance of the investment. Stock market benchmarks or indices - essentially a method of measuring the changing value of a group of securities over time - have existed since the late nineteenth century, when they were first developed as relatively simple measurement tools for groups of securities.
According to Standard & Poor’s, there are three common types of benchmarks:
q a tradable benchmark is a portfolio that pools stocks that are liquid, or tradable;
q a performance benchmark is a measurement of a broad market’s performance and risk, and may contain stocks that are less tradable than others. It usually covers 80-90% of a market’s capitalisation;
q a market indicator index is the broadest of all benchmarks and covers close to 100% of a particular market. Being so broad means that it is a more definitive measure of a market but will, almost certainly, include stocks that are not readily tradable.
Benchmark indices are useful tools for fund managers and investors to measure the performance of their investments against a common indicator of investment performance. The most important factor when using benchmarks is to ensure the comparison of ‘apples and apples’ or in other words as close to the measured investment universe as possible. According to the International Organisation of Securities Commissions1, indices basically perform several functions. In addition to measuring stock market performance, indices may, among other things, serve as performance benchmarks for active fund managers, assist in asset allocation, and provide the basis for various investment vehicles, including index-based mutual funds (index funds) and exchange-traded funds (ETFs). In addition, indices can act as the underlying for futures and options.
Some research has considered the increased liquidity that arises when a stock is added to an index, which might be explained by a number of hypotheses: the attention hypothesis, in which inclusion in an index leads to more following by analysts and investors; the information hypothesis, in which inclusion in an index conveys information to the market about a company; and the liquidity hypothesis, in which an increase in the frequency of trading leads to lower trading costs.
Panos Anastasakis, investment director of Greece’s largest property developer Babis Vovos International, argues that since the company’s stock entered the EPRA/NAREIT Global Real Estate index in April 2004, both the trading volume and institutional investor interest in the company has risen significantly. “The stock is now on institutional investors’ radar screens and this promotes the whole Greek property market,” he says.
Many of the potential risks of indexing strategies are offset because investors face a trade-off between tracking error and transaction costs (Harris, 2002). For example, trying to replicate the returns of the S&P 500 by buying every stock would minimise tracking error, but the transaction costs would be enormous. Because of these trade-offs, indexers are really self-regulating in the sense that they will vary their timing and portfolio compositions in an attempt to minimise both costs and tracking error in a highly competitive environment.
Amos Rogers, managing director at State Street Global Advisors (SSGA), explains the firm’s approach. “Usually indices are weighted according to market capitalisation. However, this approach does not account for underlying stock liquidity, which can create problems in specific segments of the market: real estate, emerging markets, small cap, etc. The EPRA Europe Liquid 40 Index was developed to provide good representation of the broader EPRA Europe, and to take into account the liquidity of the underlying stocks. This liquid subset index offers not only close representation and performance of the broader EPRA Europe, but higher liquidity and reduced transaction costs.”
In a practical sense, benchmarks are limited in representation by their underlying market. For instance, in a broad market context, country and sector weightings in the benchmark are dependent on comparative developments in individual markets. For example, table 2 compares the countries covered by the EPRA/NAREIT Global Real Estate Index and GPR 250 Index in GDP terms against the free float market capitalisation country weightings. Of the countries covered by these two indices, approximately 82% of the total world GDP is accounted for. What is evident from the table, using country GDP as the benchmark, is the fact that individual local markets are in different stages of development. For example, those countries with an established2 REIT structure in place, with the exception of Belgium, are overweight in market capitalisation terms. The three longest established REIT markets3 - the US, Australia and the Netherlands - are all overweight in both the EPRA/NAREIT and GPR benchmarks. Conversely, underdeveloped listed markets such as Germany, Japan, France, Italy and Spain are underweight in the benchmarks compared against GDP. In this case, the benchmarks do not represent the broad economic picture fully. A number of other shortfalls can be identified: transaction fees are not included, gross indices are published by the provider when the investor receives distributions net, which of course leads to tracking error. In addition, constituent changes and rule changes can be costly, so there must be clear rationale for change and in some cases there can be a high concentration in a few large stocks.
To combat some of the inconsistencies and shortfalls across markets, benchmark providers must offer the possibility to tailor indices in accordance with the appetite of individual investors. Patrick Sumner, director of property at Henderson Global Investors, explains the reasoning behind the approach used by the Horizon Pan-European Property Equities Fund, which touches on the broader economic point made above: “Investors in this fund are looking for a broad European spread of risk, and having half the benchmark weight in the UK is clearly not in line with that strategy. Some strategies limit the weight to 20–25%, but we are happy with the EPRA method that takes a simple average of the UK’s unrestricted weight (50%) and its share of European GDP (16%) to arrive at 33%.”
Frans Annokkee from Global Property Research (GPR) comments, “GPR has a specialty in constructing tailor-made indices. For example hedged indices, a global REIT index, a net index to correct for withholding taxes, to name just a few in the universe of possibilities. With this dedicated service we are able to provide investors and asset managers with benchmarks that are in line with their investment strategies and representative for their portfolio”
Léon Muller of Dutch pension fund PGGM says, “Ultimately we wanted a global real estate index. For benchmarking our tactical investments we are very comfortable users of the GPR 250. We have chosen for the GPR 250 because at the time it was the only worldwide consistently constructed benchmark, where the underlying assets are allocated at a country level and not according to country of primary listing. Rafeal Huerta Torres, portfolio manager at ABP, one of the largest pension funds in the world, explains its choice of the EPRA/NAREIT benchmark, “We had been looking for a new index which would accommodate our needs. One of the major issues when investing in real estate stocks is the lack of liquidity. We chose EPRA/NAREIT because it acknowledges this specific issue and adjusts the index series accordingly. This is carried out through free float correction and a filter on liquidity of each stock. This ensures that we use a benchmark that is replicable and we can make most effective use of our tracking error.”
Nick van Ommen, CEO of EPRA, outlines the focus for the EPRA/NAREIT Index family, drawing on the launch of the EPRA Eurozone & EPRA UK ETF products by AXA Investment Management, “From the launch of the EPRA Europe Index in May 2000, we targeted exchange-listed derivative products. We see the introduction of an exchange-listed derivative market on real estate stocks as a fundamental development for the sector. The European market is the first step, step two is North America, followed by Asia.”
A choice of global real estate benchmarks is advantageous for the investment community. The simple fact that there is competition amongst the index providers means that providers are kept ‘on their toes’. Benchmarks are a product of their environment, and while attempting to replicate the underlying market, in broader terms, they may deviate from broader economic themes. Tailored versions of benchmarks are made available by the three major real estate index providers mentioned earlier; investors selecting the provider they feel most comfortable with, in terms of the six design fundamentals. With the further developments in REIT structures around the world, and the growing number of real estate related products being launched in the market, the demand for real estate benchmarks is set to continue. The challenge for the benchmark providers is to offer investors commercially appealing products, with a view to expanding understanding and investment in the asset class.
Fraser Hughes is research director of EPRA