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A Guide to Equity Index Construction

By Daniel Broby

Overview

Equity indexes must be constructed by a defined set of transparent rules. This accessible handbook provides clear guidelines and critical insight into the science and methodology of index construction.

Publish date: 2 Apr 2007

Availability: In stock

£99.00
OR

Book description

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 Euros 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.

Book details

ISBN
9781904339779
Publish date
2 Apr 2007
Format
Size
155mm x 235mm

Author biography

Daniel Broby

As a senior figure in the asset management industry, Daniel Broby is a champion of capital markets. His focus on high level principals, integrity and best practice underlie his professional success.

Daniel built his career on the back of a strong grounding in finance theory. He has an MPhil in economics and an MSc in investment analysis. He was elected an individual member of the London Stock Exchange in 1990; is a Fellow of Chartered Institute of Securities and Investment; a Fellow of CFA UK; and a Visiting Fellow at Durham University. He was presented with the CFA Institute’s Society Leader Award in 2006.

Daniel has had a number of C’ level positions at the largest asset managers in Scandinavia and Russia. These include chief executive officer, chief investment officer and chief portfolio manager. His career, however, has revolved around the London market. He was a board member of CFA UK, and it predecessor, for over 10 years.

Daniel’s focus has always been active asset management. His success in investment performance was recognised by Morningstar who rated the flagship fund he managed for eight years with five stars

Daniel has pioneered a number of investment solutions. He introduced the first regulated hedge fund and pioneered structured products in the Danish market. He has launched various investment funds, including a number focused on frontier markets such as Africa.

Daniel has written two highly recognised books on the profession and numerous articles for industry journals. He was commissioned by the Financial Times to write The Changing Face of European Fund Management.

Daniel has also contributed to the body of financial knowledge by writing A Guide to Equity Index Construction for Risk Books. Securities & Investment Review observed that it “explores in intricate detail the various workings of modern portfolio theory, choosing a benchmark, measuring risk and sampling and selection procedures.“ Professional Investor magazine opinioned that “rarely does a book genuinely represent a first in its field."

Table of contents

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

Testimonials

“Rarely does a book genuinely represent a first in its field: amidst the thousands of investment books published each year few investment areas have been overlooked. But Daniel Broby has alighted on a topic that is important for all investors yet, to-date, has lacked a single volume to compile all the background research and methodology.“

Colin McLean, Managing Director, SVM Asset Management for Professional Investor magazine

“Explores in intricate detail the various workings of modern portfolio theory, choosing a benchmark, measuring risk and sampling and selection procedures. It’s not a volume merely for fund groups looking to construct a clever index against which to build a new fund, nor is it just for the FTSE index analysts of this world. Students of economics and portfolio theory will find it a boon.“

Securities & Investment Review

Customer Reviews

Average customer reviews for A Guide to Equity Index Construction

An excelllent guide on index construction

That's an excellent book on equity index construction which presents a detailed step-by-step methodology. It can be used by academics as well as by fund managers and investment analysts. It also covers many topics on asset pricing in a clear way. I highly recommend this book.
Review by vas01 , 11/11/2013

Best book one can get on Index Quant

I have almost completed reading the book and found most chapters of the book excellent. The book exhaustively covers the theories applicable in Index Quant area and enhances the reader's experience with relevant examples.

Index Quant being a highly specialized and complex area within Investments, this book serves to be a model guide. In my opinion, this book is equally good for students (CFA, MBA-Finance, MFE, etc.) and for practitioners in Index Quant area. A must in the professional library of a practicing Index Quant.
Review by Kushal Shah , 11/11/2013

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