The fundamentals and the options
A benchmark is an index, or a market measurement indicator that is used to assess the risk and performance of the investment. Stock market benchmark 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. In 1896, Charles Dow created one of the earliest US stock market indices, the Dow Jones Industrial Average (DJIA).
What are the main types of benchmarks?
Today, exchanges, brokerage firms, rating services and other index providers develop and maintain a large range of stock market indices. These include national stock market indices, multi country regional and global indices, indices that represent broad market sectors (for example, financials), and indices that represent particular industries (for example, real estate).
There are in addition indices that measure segments of markets, for example the markets for large, middle and small capitalisation stocks, as well as style indices.1
According to Standard & Poor's, there are three common types of benchmarks:
■ Tradable benchmark is a portfolio that pools stocks that are liquid, or tradable.
■ 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.
■ Market indicator index is the broadest of all benchmarks and cover 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.
Main roles of benchmarking
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 Commissions2 indices perform several functions.
In addition to measuring stock market performance, indices may, among other things, serve as a performance benchmark 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.
Benefits of an index strategy
Harris (2002) discusses the benefits of indexing, including lower transactions costs and increased liquidity for stocks entering the index. Hedge and McDermott (2002) provide empirical support for these conclusions.
They 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 and IR director of Greece's largest property developer Babis Vovos International (BVIC), argues that since April 2004 when BVIC entered the EPRA/NAREIT Global Real Estate index both the trading volume and institutional investor interest in the company rose significantly. "The stock is now on institutional investor radar screens and this promotes the whole Greek property market."
What are the design fundamentals?
The design and maintenance of the benchmark should avoid any potential conflicts of interest. The benchmark provider must not be positioned in a way that can advantage or disadvantage constituents or potential constituents, nor investment banks and investors party to the benchmark. The independence of the benchmark should be safeguarded by an independent committee with broad and extensive experience; ensuring the benchmark operates in the best interests of the market.
Rigorous methodology or ground rules, in line with a global index family should be adhered to at all times, and must facilitate predictable outcomes for investors. Given the potential short-term impact on the share price and trading volume of stocks added to, or deleted from an index, it is important that the information on the rebalancing rules and methodologies adopted by benchmark providers, as well as details on proposed benchmark revisions, are widely available, on a timely basis. Predictable benchmark composition backed by fully transparent index reviews, offers the backbone to clarity and understandability for investors.
The benchmark must cover the major aspects of a market, provide appropriate coverage and capture the relevant stocks. In addition, the benchmark must anticipate and respond to changes in the market, to ensure it remains as representative of the underlying market as possible. Accurate representation of the breath and depth of the market is important for investors to capture performance and diversify risk.
While the benchmark must be as representative of the underlying market as possible, the benchmark provider must also provide a benchmark that is investible. Investors must be able to trade the constituent stocks easily, without facing problems of liquidity, which can lead to tracking error. The benchmark must include stocks that are weighted in such a way that reflects the number of shares available for trading on an ongoing basis. The knock-on effect of maintaining a tradable underlying benchmark is that liquid products based on the benchmark, for example exchange traded and OTC products, can be issued.
The benchmark provider must maintain a stable, reliable, and consistent index series. A consistent family of benchmarks facilitates both meaningful comparisons and correlations, important when analysing market behaviour across markets, sectors and asset classes. In addition, the benchmark should offer economic benefits guaranteeing the benchmark is correctly sized for cost efficient replication and trading.
All benchmark providers must make available information relating to the benchmark. For example, does the provider offer an investor/index service during the trading hours of the benchmark? The service team must be responsive to queries and act quickly and accurately in extraordinary market situations, safeguarding the accuracy of the index. The provider must issue timely announcements when changes arise and offer ‘tracker' services to guarantee users the correct constituents and weights. The benchmark service must also offer an accessible website and affordable services.
The trade-off between tracking error and
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 the tracking error versus transactions cost 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 identifies their 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, and so on."
Shortfalls in indices
In a practical sense benchmarks are limited in representation by their underlying market. For instance, country and sector weightings in the benchmark are dependent on comparative developments in underlying market - in this case the institutional quality real estate market.3
The table above right compares the major global real estate countries ranked by market size (column two). The US displays the largest underlying high quality real estate market, estimated at just over US$5trn (€4trn). Japan is around US$2trn with Germany and the UK about the US$1.2trn mark. The global total is just over US$16trn. On average, approximately 6.5% of this total is listed on major stock exchanges. However, if you examine the percentages across countries the figures vary considerably. In the US the figure is close to 10%, whereas taking the largest economy in Europe - Germany - the portion of real estate listed on the German stock market is significantly under one percent.
At an aggregate level, Europe comprises just under 40% of the underlying global commercial real estate market, North America approximately 35%, Asia-Pacific 20% and Latin America around 5%. However, the stock exchange listed real estate market tells a different story. North America makes up just under 50%, Asia-Pacific close to 30% and Europe slightly over 20%. What is evident from the table, using country the underlying real estate market as the benchmark, is the fact that individual local markets are in different stages of development. In this case, the benchmarks do not represent the broad economic picture, or underlying market fully. A number of other shortfalls can be identified: Transaction fees are not included in index performance; gross indices are published by the provider while 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 4 and there in some cases there can be a high concentration in a few large stocks.
In order 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: "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%."
A choice of Global Real Estate benchmarks is beneficial for the investment community. The simple fact that there is competition among 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, or underlying market themes.
Tailored versions of benchmarks are made available by the real estate index providers; investors selecting the provider they feel most comfortable with - in terms of the six design fundamentals highlighted in the article. 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 at the European Public Real Estate Association (EPRA)
Footnotes: 1.There are two primary types of style indices: growth and value indices. In general, value indices are comprised of stocks that are priced relatively cheaply based on their current earnings, while growth indices are comprised of stocks with relatively high prices (compared with current earnings) that are expected to grow strongly. The criteria for classifying a stock as ‘value' or ‘growth' vary among index providers. Style indices may be used for asset allocation purposes or as a benchmark for active fund managers with a value or growth investment style.
2. Indexation: Securities Indices and Index Derivatives, Report of the Technical Committee of the International Organisation of Securities Commissions, February 2003.
3. Estimates exclude residential real estate. Full article explaining methodology available from www.epra.com.
4."Guiding principles for an equity benchmark" - The Tyranny of the benchmark, Bacon & Woodrow, June 2000.