Management guru Peter Drucker is attributed with the statement, “You can’t manage what you don’t measure.” and whilst we know that is not completely true, it does help define success.
Having a measure of success helps define a goal to achieve and in the world of investment management, success often comes down to performance compared with a benchmark. Whilst most times this is a fairly simple, benign and obvious issue, there are many examples where benchmarking is done poorly, can be misleading, and ultimately increases risks, unbeknownst to the adviser or investor. Individual investors and customised client portfolios of financial advisers rarely have benchmarks.
This article looks at good benchmarking, bad benchmarking, plus a few tricky issues for consideration. An important part of the investment management process is performance analysis, whether up-front during investment selection or during the review phase, and choosing the right benchmark should be integral.
What is a good benchmark?
In essence, a good benchmark is representative of a strategy’s investment universe and is therefore representative of its risk and return characteristics. This means some good traits for benchmarks may include:
- Clearly defined underlying securities and their weights
- It can be invested in passively
- Having clear and frequently calculated rules behind its creation
- Being consistent in its intended style or bias
Satisfying these characteristics is often relatively simple; there is little difficulty in finding suitable benchmarks for most strategies. For example, an Australian equity strategy may be focused on small caps, large caps, or even absolute returns, but if its mandate dictates that its investment universe is the top 300 stocks listed on the Australian Securities Exchange, an appropriate benchmark may be the S&P/ASX 300 Total Return index. This benchmark is even appropriate for the small cap-focused strategy if it allows investment in larger companies. If the small cap strategy is excluded from investing in the top 50 companies, then its benchmark could become the S&P/ASX 300 Total Return minus S&P/ASX 50 Total Return.
Some of the more well-known benchmarks, and their respective asset classes, include:
- S&P/ASX 200 Total Return – Australian equities
- MSCI World GR – global equities
- Bloomberg Ausbond Composite – Australian bonds
- Bloomberg Barclays Global Aggregate – global bonds
Each of these has the above-mentioned traits of a good benchmark.
Unfortunately, there are many strategies using inappropriate benchmarks. The main culprits are often in absolute return, credit or high-yield debt, CPI-plus and pretty much any risk strategy that uses cash (or CPI) as a benchmark. Cash and CPI may well be related to an investment objective, particularly given their definitions as the risk-free rate and the expectation to outperform; however, neither will be representative of strategy risks.
Similarly, when a strategy starts to involve investing outside of the universe of its benchmark, it may be time for a new benchmark. Investing outside a benchmark may change the risk and return characteristics of a strategy so that comparisons become inappropriate and, therefore, investments become riskier than realized. Think bond strategies that move up the credit curve and invest in unrated securities, despite having a benchmark that may be cash or investment-grade quality.
Cash will always fail the test of a good benchmark for any risky strategy, as it will never be representative of the investment universe. The investment industry is largely built on the belief that higher risk is required to produce higher return, so over the long run, of course risky strategies should outperform cash if that risk is remotely fairly priced; that does not mean the strategy has exhibited appropriate return or risk to achieve it.
Mixing benchmarks with portfolio construction method
Many strategies will be described as ‘benchmark unaware’. Being benchmark unaware has little to do with how the success of a strategy is measured and is more a reflection of portfolio construction methodology. In other words, a benchmark-unaware portfolio is probably constructed with little consideration of its asset-class benchmark. It may hold only ‘best ideas’ that are weighted according to conviction of success and not their market capitalisation. However, to ascertain whether such a strategy is successful, it is still appropriate to measure it against a benchmark that is representative of the investment universe.
For example, an absolute return equity strategy may be described as benchmark unaware, with the ability to invest in any equity market in the world. In this case, the benchmark should be something like the MSCI All Countries World Index (ACWI) and certainly not the frequently seen cash or cash-plus benchmark. The ACWI will be far more representative of the risk the strategy and if there are likely to be significant cash holdings on a regular basis, then perhaps a strategic or expected level of cash could be included in the benchmark definition. Confusing how a portfolio is constructed does not necessarily change the risk/return profile of a strategy, as risk-adjusted return above a traditional benchmark still requires significant skill in a manager, no matter the level of active or idiosyncratic risk.
Multi-manager problem can turn into a multi-benchmark problem
Most superannuation funds and financial planners use a multi-manager approach to designing investment portfolios. Because asset allocation is a key part of the portfolio construction decision, each asset class should be appropriately benchmarked, which ultimately moves the underlying manager selection towards strategies that produce the desired asset class characteristics.
Where many investors start to make mistakes (or at least increase risk), is that there is often little consideration of the asset class benchmark, and strategy selection can become more focused on the strategy’s own benchmark. It is possible to have all underlying strategies outperform their own benchmarks but underperform the asset class benchmark.
One of the more common examples of this is the inclusion of small cap Australian equity strategies within the Australian equities asset allocation. Numerous performance analyses over the years have demonstrated outperformance by active managers in the small cap space, so the inclusion of these strategies is based on this alpha potential. The fundamental belief is that small caps are a less efficient market, enabling active managers to exploit opportunities to produce excess returns. However, what is sometimes ignored is the ability of small caps to produce risk-adjusted outperformance against the asset class benchmark, which may be the S&P/ASX 300 or MSCI Australia index. Alpha amongst small caps does not mean alpha amongst large caps.
Another example is infrastructure. Performance analysis across the infrastructure suite of products in Australia is often troublesome, as it appears almost every strategy has a different benchmark; understanding whether one strategy is potentially superior to another can be difficult if looking for outperformance. Different benchmarks between strategies simply make for apples-and-oranges comparisons.
What portfolio constructors must focus on is comparison of strategies to their own asset class benchmark and consideration as to whether a strategy will outperform it. Taking this approach should provide better insights to relative performance and relative risks. Apples-and-apples comparisons are essential for better portfolio construction decisions.
With the significant growth in exchange traded funds, smart beta, and multi-factor investing, benchmarking is becoming a multi-layered exercise. Assessing strategies with a traditional asset class benchmark continues to be important, but separating determination of success from style or security selection is also important – you should know what you are paying for. Assessing strategies to their own style benchmark enables a deeper understanding of manager capability.
For example, it is widely accepted that a value bias across most equity markets around the world has produced outperformance compared with traditional market cap-weighted benchmarks. Largely thanks to ETFs, it is much easier and cheaper to buy style indices, like value; assessing an actively managed value strategy against a value benchmark will go towards understanding whether the manager is skilled at stock selection or is simply successful on the back of the systematic value tailwind. Why pay active fees if you can get a similar result from a lower-cost passive strategy that has the desired style?
What to do?
This article has touched on a few issues around benchmarking but there are many others that can be addressed another time. There are distinct lessons that can enable better strategy analysis and, therefore, improve portfolio management decisions. The main lessons this article has touched on include:
- Choose your own benchmark that reflects the investment universe of the portfolio (or asset class) you are designing.
- If your investment philosophy dictates a preferred style, then choose a secondary benchmark that is reflective of that style.
- Assess potential strategies against your chosen benchmark(s) to gain a better understanding of the relative risks and of course, whether you believe there is potential outperformance or risk-adjusted value-add.
- If a strategy manages to a different universe or particular style than yours, assessing the manager against benchmarks that reflect their investment universe or style can help determine whether they are skilled, lucky or otherwise; this is secondary to the desired characteristics of your own measure of success.
Ultimately, good benchmarking is simply about creating apples-to-apples comparisons to better measure success. Comparisons may be of return, risk, or a range of other metrics. Be careful of mixing benchmarks with objectives; do not accept benchmarks not reflective of a strategy’s investment universe.
Improved measures of success can lead to more robust portfolio management and better results for investors.
Michael Furey is principal, Delta Research & Advisory.