A Guide to Equity Index Construction (2nd Edition)
First published:
ISBN: 9781782724483
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Modern portfolio theory and the benchmark index
Preface
Acknowledgements
Introduction
Which benchmark?
Modern portfolio theory and the benchmark index
Sampling and selection
Construction method
Making the index investable
Collection and processing of data
Servicing and maintenance
How to handle industries
How to handle countries and currencies
Factor indices and smart beta
Innovative indices
The commercial indices
Indexation and exchange-traded funds
Bespoke “custom-made” indices
Tying it all together
Appendix: The GICS methodology
Bibliography
Disclaimer
INTRODUCTION
“In choosing a portfolio, investors should seek broad diversification. Further, they should understand that equities – and corporate bonds also – involve risk; that markets inevitably fluctuate; and their portfolio should be such that they are willing to ride out the bad as well as the good times.”
—Harry Markowitz, founder of MPT
This chapter covers the construction of indices in a scientific manner, distinct from benchmarks that do not take risk into account. The theoretical basis for such indices is the CAPM, explained in more detail later. This is a financial model widely used in finance and investment to determine the required rate of return for an investment or asset. The primary focus of this genre of indices is on the “efficiency” of indices and their representation of the “market proxy”. A market proxy is defined as follows.
Definition 3.1. Market proxy Market proxy is a substitute for the market portfolio, which includes all investable assets in the market in their proportionate weights.
In this respect, this chapter focuses on equity indices that represent market proxies derived from MPT as postulated by Markowitz (1952) and explained later in the chapter. While
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