Understanding Your Benchmark

June 24, 2013


Indexes are often praised as being fully transparent and rules-based, with published rule books spanning hundreds of pages. Within those rule books, many smaller details can also have a significant influence on the performance of a benchmark and its characteristics. In this article, we highlight three areas that can easily be overlooked, but which may be of interest for investors seeking a 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 rule books and compositions with great care in order to fully understand their effects on the investment.

The Treatment Of Corporate Actions
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 indexes, 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" indexes, the calculation of the index often involves additional complexities that may be overlooked by those evaluating an index's methodology. This is especially true in the area of 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 behavior and performance.

To illustrate this, below we examine different types of corporate events and their treatment in indexes.

Regular Dividends
Regular dividends are a relatively simple event. The holder of the index portfolio receives a dividend payment. In price indexes, this leads to a drop in the index value. In total-return indexes, this price drop is adjusted for in the index calculation. So far, so simple; however, there are three different ways in which this reinvestment can be calculated:

Option 1: Reinvestment in the Index Portfolio – In this case, the received cash is redistributed across all components of the index. This means that an investor tracking the index will need to purchase additional shares in all components of the index according to their current weighting, up to a total amount equal to the dividend payment. This method has the advantage that the portfolio represents the true market capitalization weightings of the underlying market correctly at all times. On the downside, this adjustment generates relatively large amounts of trading activity and therefore costs, as a trade needs to be made in all the components of the index.

Most international index benchmarks, including indexes from Stoxx, MSCI and FTSE, follow this methodology.

Option 2: Reinvestment in the Single Stock – In this case, the cash received is reinvested only into the stock paying the dividend. An investor tracking the index would therefore purchase shares of that stock for the amount of the payment received. This artificially increases the market capitalization of the affected stock to a synthetic level, equivalent to that observed prior to the payment. Reinvestment into the entire portfolio still happens, but not until the next regular rebalancing of the index. This method reduces portfolio adjustment costs, as transactions only take place in one share in the portfolio.

This methodology is used by the indexes of Deutsche Börse AG, including the DAX index.

Option 3: No Reinvestment – The third option is of a more theoretical nature only and assumes that the amount paid out is kept as cash until the next rebalancing of the index, where it will be reinvested in the entire portfolio. While this method theoretically minimizes transaction costs, it also skews the returns of the index, as during dividend seasons, a significant part of the portfolio may not actually be invested in the equity market.

This methodology is not commonly used in any major indexes.

From an index calculator's perspective, one of the most complex corporate actions is the event of a spinoff within the index. In this case, a member company of the index spins off parts of its business into a separate corporation, which is itself typically stock market listed. To ensure a smooth adjustment, the effects of such corporate actions need to be reflected in the index. Such adjustments need to be performed on an ex ante basis; in other words, the adjustment needs to take place at the market close on the day prior to the ex-date of the event in order to ensure that no jumps in the index occur. In theory, it is fairly easy to determine the theoretical post-spinoff price for the share in the index using a simple formula, as shown below:

As for all index adjustments, this calculation assumes a ceteris paribus environment post spinoff; in other words, the corporate action has no effect on valuations. So index compilers assume that the valuation of the "old" company is equal to the sum of the valuations of the two companies after the spinoff takes place.

The potential problem when this calculation is performed prior to the ex-date is that the price for the daughter company PB cannot be evaluated objectively or quantitatively. The valuations forecast for spinoffs by market analysts and participants often differ widely, even for very large and well-covered constituents of major market indexes.

In addition, such valuation estimates may imply a higher total valuation of the two parts following the spinoff. But any such potential increase (or decrease) in value cannot be reflected in the index, as it would violate the ceteris paribus adjustment principle and not accurately capture the return made by the investor in the index, leading to tracking errors.

Many international index providers do, however, calculate the adjustment based on estimated or synthetically constructed hypothetical prices for the daughter company (in the case where the daughter company does not become an index component itself, as is the case in most blue chip indexes with a fixed number of components).

Technically, this requires a tracking portfolio to sell the daughter shares at this hypothetical price at the close prior to the event in order to maintain zero tracking error. In practice, of course, this transaction can only occur once trading in the new instrument actually starts: typically, the morning of the next trading day. Any difference between the price actually realized in that transaction and the hypothetical price used in the index calculation does generate some tracking error against the index.

An alternative to this adjustment method was first introduced by Deutsche Börse AG for the DAX family of indexes in 2003, and has since been adopted by other index providers. The new method includes the daughter company as an index component for one extra trading day, irrespective of whether the company becomes eligible for the index, meaning the index's component count also increases by one for this extra day. The inclusion price is then mathematically irrelevant, since the formula for the adjusted price ensures that the sum of the market capitalization of the two parts equals the market capitalization of the pre-spinoff company. As the trading starts in both components, both will receive current market prices and the index will update accordingly. This method ensures all price movements due to a potential new valuation are actually recognized as part of the index's performance, in the same way an investor would experience them in his or her portfolio.

At the end of the first post-spinoff trading day, the new component is then excluded at its closing price, and the reinvestment of the resulting cash distribution is handled according to the regular process specified in the index rules. This method effectively ensures that even a complex corporate action such as a spinoff can be implemented by all index investors without experiencing any tracking error against the index calculation.

As a side effect, this leads to the special case of an index with a fixed number of components carrying more than that number for a short time. This was observable in the DAX index on Jan. 31, 2005, when the rule was first applied to the Bayer's spinoff of Lanxess, leading to 31 components for the first, and so far only, time in 25 years of existence of the DAX index.

How Refinancing Rates Affect Leveraged Indexes
Leveraged indexes apply a leverage factor to the daily return of a chosen base index. Leveraged indexes are available for all major benchmarks and from all major global index providers, with the leverage factor typically ranging from plus eight to minus eight. For simplicity, we will consider a two-times leveraged index for this part of the article.

A leveraged index with a factor of two aims to provide the investor with twice the daily return of the base index. However, to ensure that investors can actually replicate the index, some additional factors need to be considered.

To calculate the leveraged index, index calculators assume that for every investment made into the base index that a loan of the same amount is taken out and also invested into the base index for one day. At the end of the day, the loan is theoretically repaid, and the long position in the index is liquidated; hence, generating twice the return of the underlying index for that day. The index calculation must therefore reflect the costs of taking out that loan.

The index formula for the leverage index with a factor of two is:

When leveraged indexes were first introduced, the interest rate used in Formula 2 was the overnight financing rate. In the case of euro-denominated indexes, the daily EONIA rates were used. In practice, however, products tracking these indexes would not reset their positions on a daily basis and instead decided to provide financing at a longer-term rate.

Since the outbreak of the financial crisis, the financing spread between a regular one-year Euribor rate and the annualized EONIA swap rate has significantly increased, as shown in Figure 1, making it increasingly difficult to replicate the performance of leveraged indexes accurately.

As can be seen from the chart, until the middle of 2007, this financing spread was negligible in size; hence, it did not impact the tracking of leveraged products. But since then, in response to the appearance of the spread, many index providers have decided to adjust the refinancing methodology to incorporate the liquidity spread in the index calculation, helping index-tracking funds to track more accurately. The adjusted formula now reads:

In the new formula, the daily financing spread between the one-year Euribor rate and the annualized EONIA swap rate is an additional deduction from the index's performance.

Figure 2 illustrates the relatively minor difference in performance between the two leveraged index methodologies for the Euro Stoxx 50 Net Return Index over a 15-year period.

On a monthly basis, however, in times of high liquidity spreads, as we have observed from 2007 onward, the monthly performance differential between the two index methodologies may exceed 10 basis points, as Figure 3 illustrates.

While differences in financing costs made little impact until the financial crisis, Figure 3 shows that the choice of reference rate can have a significant impact on an index's performance. Using a reference rate that is close to the actual replication costs facing those tracking the index ensures that products with low tracking errors can be offered to investors.

Country Exposures In Standard Indexes
Another topic of interest in benchmark construction, and one that is becoming increasingly important for investors, is how companies are allocated to a home market. In the past, this allocation has been relatively easy, as for most companies, the country of listing is strongly correlated with the location of the company's business activities. However, with increasing globalization in corporate activity and in financial markets, the process of allocating companies to countries is becoming much less straightforward.

Increasingly, stock exchanges compete for the primary listings of companies from less-developed markets and are more and more successful in doing so. Hence, we see many more listings of corporations outside of their home markets. Index providers typically use three main criteria to determine the country classification of companies:

• Country of incorporation
• Primary listing
• Point of major trading turnover

However, economic exposure does not commonly feature in the index criteria. In "normal" cases, this works sufficiently well not to cause too many problems, but with the increasing internationalization of listings, certain scenarios can lead to undesirable results, as the two hypothetical examples below highlight.

Example 1: A corporation operating exclusively in an emerging market country seeks a stock market listing in a developed market.

The company's risk exposure is exclusively in its original home market. However, the standard practice employed by index providers will typically classify the stock according to its primary listing. In many cases, the company will also be incorporated and have its headquarters in the market of the listing. Hence, the index in the country of listing will now include a risk element that investors in that market are not necessarily seeking exposure to. This requires investors to go beyond the index rules and screen index portfolios for potentially unwanted exposures before investing.

The well-known FTSE 100 Index includes multiple examples of this. For example, the index constituent ENRC (Eurasian Natural Resources Corporation) is headquartered, incorporated and listed in the United Kingdom. But the operations of this multinational resource company are currently limited to Kazakhstan, China, Russia, Brazil and Africa. The company's only connection with the U.K. market—which an investor might be seeking to replicate via an index fund—is via its incorporation and listing, not via the economic exposure of its underlying business activities. While most global index providers, such as FTSE, MSCI and Stoxx, also classify the share as a U.K. stock, other national indexes—such as Germany's DAX index—have provisions in their rule books to prevent the inclusion of companies without economic exposure to the target market.

Example 2: A corporation operating in country A is incorporated in country B and eventually listed in a third country, C.

In this case, the least ideal solution seems to be a classification in country B, the country of incorporation, since the company has the least connection to this market from the perspective of economic exposure and risk. The company's country of listing also has no connection to its business activity, but an argument may be made that the corporation is seeking exposure to investors in that respective country. Finally, the country of incorporation makes sense from an investor's point of view, but there are implementation issues to consider if, for example, country C lies in a different time zone, or trades there take place in a different currency. This would create other problems for investors. Therefore, from an implementation perspective, it remains the simplest solution to go with the country of primary listing; but the risk of creating unwanted exposures in a portfolio remains.

An example—again from the United Kingdom—is the company Polymetal International. The company is headquartered in St. Petersburg, Russia, and operates a port-folio of gold and silver mines in Russia and Kazakhstan. The company is incorporated in Saint Helier, Jersey, and listed on the London Stock Exchange.

One reason for many of these tricky questions of country exposure is the emergence of London as a listing center for—among others—mining and natural resources companies from many less-developed markets. Polymetal International is also included in the FTSE 100 Index. The S&P 500 Index also contains a number of corporations operating globally, some with listings outside of the U.S. However, in this case, the clear majority of companies has a strong U.S. heritage, so questions of economic exposure are not so pronounced.

Currently, the amount of potentially unwanted risk in national equity indexes is still relatively low, as the indexes' overall economic exposure tends to match what one might consider investors' "target" replication. But the example of the FTSE 100 Index and, to a smaller extent, the S&P 500, shows that foreign exposures are beginning to make increasing inroads into the composition of some major benchmarks.

The examples also show that for some companies there is no correct answer when it comes to country classification. One alternative solution to overcome the weakness of the traditional approach of dissecting the world primarily according to the place of listing may be to construct indexes according to economic exposures rather than by traditional methods. Such indexes exist already for emerging markets, but this concept may be expanded to single-country exposures as well.

In this article, we have shown how some of the less-well-known index rules can have a substantial impact on indexes' performance and risk exposures. We illustrated how alternative approaches to the treatment of corporate actions, the interest rates used in leveraged indexes, and the country classification of equity index constituents are all of potential importance to the investor tracking an index, or using it to measure performance. Understanding your benchmark is crucial.


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