Strategy Benchmarks - From the Investment Manager's Perspective
Authors: David E. Kuenzi
Source: The Journal of Portfolio Management
Date: Winter 2003
Size: 73824 Bytes
Broad-market indexes have long been used as benchmarks by investors and fund managers. Nevertheless, with the development of numerous sophisticated investment styles, such broad indexes do not accurately reflect the specific features of certain strategies. Since benchmarks play a central role in portfolio risk management and portfolio attribution analysis, investors and fund managers may be compelled to construct “strategy” benchmarks to ensure a robust implementation of the investment process. The merit of this article is not only to state when it is crucial to create customized benchmarks but also to show how the choice of an inappropriate benchmark may distort the risk and performance analysis.
The first step of a “top-down” investment process is to determine the strategic allocation, namely the average portfolio allocations over time. The second involves defining the tactical allocation, i.e. the over-/underweighting of the strategic portfolio’s risk exposures within fixed risk limits. As a consequence, following an abundant amount of literature on this issue, the author argues that the performance of a portfolio is driven by three components: the publicly available index, the extent to which the benchmark deviates from the publicly available index (i.e. manager’s style exposure) and the extent to which the portfolio deviates from the benchmark (i.e. manager’s active position). The author argues that if one cannot find any publicly available index representing neutral weights for the strategic portfolio, a customized or strategy index must imperatively be constructed. As a result, a strategy benchmark will generally be needed as soon as a manager has a style bias with respect to the different indexes available on the market. Like all benchmarks, the strategy benchmark must be unambiguous, investable, measurable, appropriate, and reflect the portfolio manager’s current investment philosophy.
As noted by the author, while investors accept to bear the benchmark risk, portfolio managers are supposed to bear the active risk. Consequently, the concept of risk controls becomes distorted if the manager employs a benchmark that is not representative of true neutral weights. If the publicly available index does not represent neutral weights for the portfolio it is a poor benchmark for both the purposes of gauging active risk and attributing performance. It would be like comparing apples with pears. In the same vein, using an inappropriate benchmark leads to built-in tracking error, which in turn distorts the information ratio and makes manager evaluation much more difficult. The author also shows how using a strategy benchmark enables active management to take place in the context of rational decisions to overweight or underweight factor exposure compared to the benchmark. In short, the author stresses the importance of the strategy benchmark for both the portfolio manager and the investor.