Understanding Your Benchmark
|April 30, 2013|
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Indices are often praised as being fully transparent and rules-based, with published rulebooks spanning hundreds of pages. Within those rulebooks, many smaller details can also have a significant influence on a benchmark’s performance and its characteristics. In this article, we highlight three areas that can easily be overlooked but which may be of interest to investors seeking specific exposure or wanting to invest in a derivative product based on such an index. We look at the treatment of corporate actions, interest rates and country exposures to illustrate why it is necessary to consult and study index rulebooks and compositions with great care to fully understand their effects on investment.
When looking at an index, investors often focus on its selection methodology (i.e., which components are in the index) and its weighting scheme (i.e., which component or components influence the index most, and to what extent). From the perspective of these two dimensions only, the majority of indices, and certainly most major market benchmarks, are actually quite simple. Selecting the largest and most liquid stocks from a country, region or market segment and weighting them by their size does not hold any major surprises. However, even for “plain vanilla” indices, the index calculation often involves additional complexities that may be overlooked by those evaluating an index’s methodology. This is especially true in the treatment of corporate actions. In other words, the rules governing how capital raisings and other corporate events are reflected in an index can have a significant impact on its behaviour and performance.
To illustrate this, below we examine three different types of corporate event and their treatment in indices.
Option 1: Reinvestment in the index portfolio
Most international index benchmarks, including indices from STOXX, MSCI and FTSE, follow this methodology.
Option 2: Reinvestment in the single stock
This methodology is used by Deutsche Borse indices including the DAX index.