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Features
Indices - October 18, 2006

Assessing the Quality of Stock Market Indices: Requirements for Asset Allocation and Performance Measurement

At a presentation to the members of the Af2i (French association of institutional investors) in Paris on September 12th, Noël Amenc, Director of the EDHEC Risk and Asset Management Research Centre, warned his institutional audience about the dangers of relying solely on stock market indices as a benchmark for their investment management performance.

For the vast majority of European institutional investors, constructing a benchmark and measuring the performance of their portfolio in relation to the benchmark are central to their investment process. And, very often, the chosen benchmark is a market index and/or a combination of market indices.

Since their design is not affected by the securities chosen by managers and since they benefit from the sound reputation of major financial institutions, credit rating agencies and major international stock exchanges, market indices appear to be the ultimate reference not only for strategic allocation but also as a measure of investment management performance. Evaluating the quality of these indices as a benchmark is therefore a question that is essential to institutional investors.

It is the importance of this question that led Af2i (French association of institutional investors) and EDHEC to carry out research on the main market indices used by European investors. This work received the support of BNP Paribas Asset Management and UBS Global Asset Management.

The French association of institutional investors has 61 members, with a total of €700bn in managed assets. Its active members hold financial management positions in French institutions with an active role in the long-term management of capital reserves.

The results of the Af2i/EDHEC study, entitled Assessing the Quality of Stock Market Indices: Requirements for Asset Allocation and Performance Measurement, clearly show that most market indices used as a reference by investors are neither efficient nor stable in terms of style and sector exposure.

This inefficiency and instability is a source of underperformance and poor risk management and results in a failure by investors to optimise the risk-return trade-off of their portfolios.

Af2i and EDHEC offer solutions to these difficulties and recommend, in particular, that investors favour the construction of benchmarks based on geographic zones using combinations of style or sector indices and that they use a ‘completeness core portfolio’ approach in order to ensure that their asset allocation is more stable.