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LOS b: Discuss the trade-offs involved in constructing international indexes, including (1) breadth versus investability, (2) liquidity and crossing opportunities versus index reconstitution effects, (3) precise float adjustment versus transactions costs from rebalancing, and (4) objectivity and transparency versus judgment. fficeffice" />

Q1. ANZ Asia equity index is a new entry into Asian market indices. The index has better coverage especially in the South Asian markets as compared to its more popular rivals. The index has coverage of 90% of all stocks listed in the constituent markets. Which of the following statements best describes the index?

A)   Breadth is high, liquidity is low, and crossing opportunities are high.

B)   Breadth is high, liquidity is high, and crossing opportunities are low.

C)   Breadth is high, liquidity is low, and crossing opportunities are low.

Correct answer is C)         

Since the index is fairly comprehensive (90% coverage), breadth of the index is high. However due to the high breadth and being fairly new in the market, the index is not very liquid. Also lower popularity (new index) translates into lower crossing opportunities.

 

Q2. Transaction costs in general are higher for:

A)   precise float adjustment and more popular indices.

B)   precise float adjustment and less popular indices.

C)   float adjustment bands and less popular indices.

Correct answer is B)

Precise float adjustment results in frequent rebalancing and higher transaction costs. More popular indices have higher liquidity and lower transaction costs.

 

Q3. The effect of index reconstitution is more severe for:

A)   less popular indices because of lower price pressure.

B)   more popular indices because of higher price pressure.

C)   less popular indices because of higher price pressure.

Correct answer is B)

Index reconstitution results in added demand for a stock when it is added to the index (due to index replicators trying to buy) and added supply for a stock when it is deleted from the index. (due to index replicators trying to sell). The result is that managers are forced to buy added stocks at high prices and sell deleted stocks at low prices. This price pressure is more severe for more popular indices (more replicators).

 

Q4. Portfolio managers tracking international equity indices have a tradeoff between breadth and investability because:

A)   lower breadth results in higher investability and higher transaction costs.

B)   higher breadth results in lower investability and higher transaction costs.

C)   higher breadth results in higher investability and lower transaction costs.

Correct answer is B)

Index breadth refers to the number of companies covered by an index. Higher breadth means that a larger number of companies are covered, however, that results in lower investability (liquidity issues for smaller companies in the index) and higher transaction costs.