Benchmarking has increasingly become a de facto aspect of most investment programs today. The ubiquitous nature of benchmarks has led index providers to create indices representing just about every asset class, country, and investment style in the market today.
With benchmarks covering all types of assets and investment strategies, it makes sense to choose carefully and only after deciding one’s investment goals and risk tolerance.
Despite their widespread use for relative performance evaluation, benchmarks still can’t fully evaluate whether an investment program will achieve its ultimate goal: meeting investors’ objectives.
Whether investors should benchmark is the easy question. More difficult ones are what to benchmark, and how.
In the old days, pension funds basically had the SMI index for equities and the SBI index for bonds. The increase in complexity created a whole new set of issues for investors: how does one go about setting up a benchmark of his portfolio?
For asset classes not having suitable market-based benchmarks there has been a rise in popularity of reference-rate plus margin benchmarks. Since this benchmark is not explicitly tied to market cycles, it is best used when evaluating portfolios over a long-term basis.
As such, a benchmark based on an absolute target return measure may be consistent with this objective, but absolute benchmarks grow in usefulness as the length of time considered grows – and, conversely, these benchmarks are less useful in assessing short-term performance, as market noise may obscure the longer term performance trends.
Reference-rate plus margin and absolute benchmarks have two major drawbacks. Firstly, they are best suited for long time horizons, thus not suitable for investors tracking on a shorter time horizon and are not risk-adjusted.
As far as the benchmark suitability is concerned, suppose for instance an investor who believes that the CHF will weaken may choose to invest in securities denominated in other currencies because they will increase in value if the Swiss Franc falls. Under the circumstances, he takes an exposure on foreign holdings and is fully exposed to changes in currency values.
He would appropriately use an unhedged index to reflect and track more accurately his positions.
However, investors such as pension funds seeking capital preservation or to meet liabilities typically opt for indexes that hedge currency risk (fully or partially) and avoid the volatility that currency investing can bring.
Despite the availability of more sophisticated indices, it is up to investors to reflect on how they use them. Benchmarks should be used with a healthy degree of skepticism and additional metrics linked not only to return objectives but also to risk elements including asset quality and development exposure, to monitor the performance. In other words, practices today span the good, the bad and the ugly.
Investors, therefore, should engage with their counterpart in dialogue around the inherent advantages and drawbacks of the available benchmark methodologies relative to their investment policies and objectives. Because no true market index exists, investors should be aware of the limitations of various approaches and their possible consequences.
Unfortunately, when benchmarks are not appropriately selected, they could lead to decisions that can inadvertently create increased risks.
To recap, a fair and appropriate benchmark is an important tool in assessing a portfolio manager’s investment skills. The benchmark construction approach, should let investors build a benchmark that is representative of their portfolio and accounts for the different ways in which a manager can add value.
However, the investors should remember the limitation of benchmarks. Whether the benefit is for an institution such as a pension fund, investment portfolios are ultimately designed to meet some future liability. Yet, taken alone, a performance comparison relative or a tracking error to a specific benchmark tells investors nothing about whether their portfolio is positioned to meet its objectives going forward.