Indices, Index Funds And ETFs: Exploring HCI, Nonlinear Risk and Homomorphisms

710 Pages·2018·8.65 MB·English

by  Michael I. C. Nwogugu

INDICES, INDEX FUNDS AND ETF¾:
EXPLORING HCI,

NONLINEAR RISK
AND HOMOMORPHISMS
MICHAEL I. C. NWOGUGU
Indices, Index Funds And ETFs
Michael I. C. Nwogugu
Indices, Index Funds
And ETFs
Exploring HCI, Nonlinear Risk
and Homomorphisms
Michael I. C. Nwogugu
Nigeria
ISBN 978-1-137-44700-5 ISBN 978-1-137-44701-2 (eBook)
https://doi.org/10.1057/978-1-137-44701-2
Library of Congress Control Number: 2018946795
© The Editor(s) (if applicable) and The Author(s) 2018
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C
ontents
1 Introduction 1
1.1 How This Book Differs from Other Books About ETFs,
Indices and Index Funds 8
1.2 Regulatory Failure, Regulatory Capture and Regulatory
Fragmentation 9
1.3 Some Mathematical Commonalities Among Debt, Equity
and Commodity Indices 10
1.4 The Chapters: Activity Theory and HCI 11
1.5 Momentum Effects, Systemic Risk and Financial
Instability 14
1.6 The Usefulness of Alpha and Beta as Currently
Construed; and the Debate About Active Management
Versus Passive Management 15
1.7 ETFs Versus Mutual Funds Versus Closed- End Funds 21
1.8 The Case-Shiller Real Estate Indices Are Very Inaccurate
and Misleading 22
1.9 Tax Aspects of Investing in ETFs, Index-Based ETNs and
Index Funds 22
1.10 Forecasting of Stock Indices and ETFs 23
1.11 Network Analysis in Stock Indices and ETFs 23
v
vi CoNTENTS
1.12 Some Public Health and Social/Economic Sustainability
Problems (Including Climate Change and Harmful
Technological Innovation) Inherent in the Use of
Financial Indices and Index Products (Index Funds,
ETFs, Index Futures/Options and Index ETNs) 23
Bibliography 26
2 Number Theory, “Structural Biases” and
Homomorphisms in Traditional Stock/Bond/
Commodity Index Calculation Methods in Incomplete
Markets with Partially Observable Un-aggregated
Preferences, MN-Transferable-Utilities and Regret–
Minimization Regimes 41
2.1 Existing Literature 44
2.2 MN-Transferable Utility 50
2.3 The ICAPM/CAPM Are Inaccurate 54
2.4 The Traditional Index Calculation Methods (Applicable
to Many Stock/Equity, Debt, Real Estate, Commodity
and Currency Indices) 55
2.4.1 Market-Capitalization Weighted Indices (and
“Diversity” Indices) 56
2.4.2 Free Float Adjusted Indices 60
2.4.3 Fundamental Indices 61
2.4.4 Stock-Price-Weighted Indices 65
2.4.5 Trading-Volume Weighted Indices 66
2.4.6 Market-Cap Weighted and Volume-Weighted
Indices (Two Methods Combined) 68
2.4.7 Dividend-Weighted Indices 69
2.4.8 Equal-Weight Indices 69
2.4.9 Thomson Reuters’s Indices 73
2.5 Other Distortions in Traditional Indices 73
2.6 Green Bonds Indices: A Combination of Market-Value
Weighting and Fundamental Weighting 77
2.7 Bloomberg Barclays Bond Indices (Including the
“Bloomberg Barclays Global Aggregate Bond Index”):
Combination of “Market-Value” and “Fundamental”
Weighting 79
CoNTENTS vii
2.8 The S&P Dow Jones Fixed Income Index Methodology
(Combinations of “Market-Value” and “Fundamental”
Weighting) 81
2.9 The S&P Global Carbon Efficient Indices 82
2.10 The Standard & Poor’s-Goldman Sachs Index (S&P
GSCI) 84
2.11 The Bloomberg Commodity Index Family (Including the
Bloomberg Commodity Index “BCOM”) 86
2.12 The ICE BofAML Commodity Index Extra (MLCX
Family of Commodity Indices) 88
2.13 Traditional Index Calculation Methods Create
Significant Incentives for Companies to Perpetrate
Earnings Management, “Asset-Quality Management”
and “Incentive-Effects Management” 89
2.14 Conclusion 95
Bibliography 96
3 A Critique of Credit Default Swaps (CDS) Indices 111
3.1 Existing Literature 112
3.2 “Quasi-Default” Versus Reported Default: The
Difference Reduces the Usefulness of CDS Indices 113
3.3 The Credit Ratings Lag 116
3.4 The Methods for Pricing of Debt Reduces the Accuracy
of CDS Indices 117
3.5 Behavioral Effects and Externalities Inherent in the Use
of CDSs, and Which May Distort the Accuracy of
CDS-Indices 118
3.6 Financial Instability and Systemic Risk 119
3.7 The S&P CDS Indices 120
3.8 CDSs are Inefficient, Unethical and Probably Illegal 124
3.9 Conclusion 132
Bibliography 132
viii CoNTENTS
4 Invariants and Homomorphisms Implicit in, and the
Invalidity of the Mean-Variance Framework and Other
Causality Approaches: Some Structural Effects 139
4.1 Existing Literature 140
4.2 The Mean–Variance Framework Is Inaccurate 142
4.3 Implications for Systems Science and Reliability
Engineering: Invalidity of Global Sensitivity Indices
and Sobol Indices 170
4.4 Conclusion 171
Bibliography 171
5 Decision-Making, Sub-additive Recursive “Matching”
Noise and Biases in Risk-Weighted Stock/Bond
Commodity Index Calculation Methods in Incomplete
Markets with Partially Observable Multi-attribute
Preferences 177
5.1 Existing Literature 178
5.2 The ICAPM/CAPM Is Inaccurate 182
5.3 The Risk-Adjusted Index Calculation Methods Are Wrong 185
5.3.1 Free-Float Adjusted Indices 185
5.3.2 Equal Risk Contribution (ERC) Indices 186
5.3.3 “Most-diversified” (“Diversity”) Indices 188
5.3.4 “Minimum-Variance” Indices 190
5.3.5 FTSE/EDHEC Risk-Adjusted Indices 192
5.3.6 The Hang Seng Risk-Adjusted Indices 196
5.3.7 The S&P Risk-Control Index Series: S&P
Developed Market Risk-Control Index Series,
S&P Emerging Market Risk-Control Indices
and S&P Global Thematic Risk-Control
Indices 201
5.3.8 The Thomson Reuters Lipper Optimal Target
Risk Indices 205
5.3.9 MSCI Factor Indices 206
5.3.10 MSCI Risk-Weighted Indices 208
5.3.11 The Dow Jones Relative-Risk Indices 209
5.3.12 The Dow Jones RPB Indices 218
5.3.13 The FTSE StableRisk Index Series 218
5.3.14 The Minimum Correlation Indices 222
5.3.15 Risk Parity (RP) Indices 222
5.4 Conclusion 222
Bibliography 223
CoNTENTS ix
6 Informationless Trading and Biases in Performance
Measurement: Inefficiency of the Sharpe Ratio, Treynor
Ratio, Jensen’s Alpha, the Information Ratio and DEA-
Based Performance Measures and Related Measures 233
6.1 Existing Literature 234
6.2 CAPM/ICAPM/IAPT Are Inaccurate 241
6.3 Inherent Biases and Structural Effects That May Affect
Performance Measures 241
6.4 Critical Assumptions, Noise and Error Inherent in
Mean–Variance-Based Performance Measures 242
6.4.1 Error Assumption #1: All Investors Agree
About the Risk and Expected Return for All
Securities; and All Investors Have the Same
Investment Preferences Which Don’t Vary Over
Any Time Interval; and All Investors Derive
the Same Utility from Any Portfolio; and All
Investors Have Similar Decision Processes
About Investments, and All Investors Agree
About the Risk (Standard Deviation) and
Return of Every Asset 242
6.4.2 Error Assumption #2: All Investors Can
Short-Sell All Securities Without Restriction 243
6.4.3 Error Assumption #3: All Investors Have the
Same or Similar Investment Horizon, or Their
Investment Decisions Don’t Consider
Investment Horizons 243
6.4.4 Error Assumption #4: All Investors Don’t Pay
Federal or State Income Taxes, or All Investors
Have the Same Tax Rates 243
6.4.5 Error Assumption #5: There Are Minimal or
No Transaction Costs, or All Investors Have
the Same Transaction Costs 244
6.4.6 Error Assumption #6: The Investment
Opportunity Set for All Investors Holding Any
Security in the Index Is Restricted to the
Securities in the Public Markets (or in the
Specific Sub- market on Which the Index Is
Based) 244
x CoNTENTS
6.4.7 Error Assumption #7: All Investors Have the
Same Marginal Rate of Substitution (of Assets
in Their Portfolios) Which Is Constant Over
Any Time Interval, and Which Has a Fixed
and Directly Proportional Relationship with
Their Total Investable/Liquid Wealth 244
6.4.8 Error Assumption #8: For All Investors, Total
Wealth and Total Investable Wealth Are
Perceived as the Same, and Both Have No
Effect on Investors’ Perception of the Risk–
Reward Ratio 245
6.4.9 Error Assumption #9: For All Investors, and
for All Time Intervals, the Marginal Utility
of Wealth Decreases as Total Wealth Increases 245
6.4.10 Error Assumption #10: All Investors Have
Positive Total Wealth and Positive Total
Investable Wealth in Any Time Interval 246
6.4.11 Error Assumption #11: For Every Investor, the
Risk–Reward Trade-Off Is a More Important
Investment Criteria Than the Absolute
Magnitude of Returns, and/or the Investor’s
“Reference Point” (i.e. Cost of Capital, etc.) 246
6.4.12 Error Assumption #12: Bid–Ask Spreads Are
Small and Don’t Affect Investors’ Decisions or
the Calculation of Standard Deviations of
Returns 247
6.4.13 Error Assumption #13: All Losses Produce
Strictly Negative Utilities (Investors Don’t
Gain Any Utility from Tax Loss Carry-
Forwards) or Losses Don’t Have Any Utility
and Don’t Cause Regret; and There Is No
Utility Derived from Merely Holding a
Portfolio 247
6.4.14 Error Assumption #14: For All Investors, the
Non- monetary Utilities (Such as Hedging,
Long- Term Security, etc.) that Arise from
Investing Are Irrelevant 247
6.4.15 Error Assumption #15: All Investors Can Make
Investments That Earn the Risk-Free Rate at
All Times and for Any Amount of Capital 248