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Strategy

An unhappy comparison?

An unhappy comparison?

Tuesday 18th November 2014

Humans have an irresistible urge to compare their performance against their peers. As English dramatist and poet laureate, Thomas Shadwell, famously said: “No man is happy but by comparison.” Shadwell died in 1692, nearly 100 years before the birth of stock exchanges in 1773.

And still the urge lives on. In investment terms, comparison often means looking at the gap between how an investment has performed and a commonly accepted measure of that particular universe, or benchmark.

And, with passive investment on the rise since the financial crisis, the dominance of broad market benchmarks in investors’ psyche is on the increase. Today, the S&P 500 has become one of the most commonly used benchmarks by which to compare equity market performance. It is widely considered to be one of the best representations of the US stock market, and a bellwether for the US economy. In 2013, S&P Dow Jones Indices estimated more than $7trn of assets globally were explicitly benchmarked to the S&P 500 through index- tracking mutual funds, institutional funds, separately managed accounts, indexed insurance products and ETFs.

This doesn’t include the unofficial benchmarking many investors do by comparing the performance of a range of assets against this widely held barometer or investment performance. It is not uncommon, for example, to see comparisons of hedge funds’ performance reported against the S&P 500 even though those hedge funds are generally not designed to produce performance in line with this benchmark.

ONE RULE TO RULE THEM ALL?

At the holistic portfolio level, investors are increasingly adopting an outcome-oriented approach to investment, particularly as many pension funds, for example, close or move to liability-matching strategies. As such, more and more are taking a more self-centric approach to performance, focusing instead on bespoke benchmarks that capture their individual liability stream.

As Andrew Kirton, EuroPac investments head at Mercer, says: “Almost universally in today’s market, institutional investors will have their own unique investment strategy. For defined benefit pension plans, in addition, the investment strategy will evolve dynamically given the objective for many is to de-risk the portfolio over time.

“The advent of scheme-specific investment strategies is not a new development, but arguably dates from the turn of the current century when mark-to-market valuation techniques were introduced by the actuaries in response to changing accounting standards. At the total portfolio level benchmarks are often expressed as a ‘journey’, over a specified time period to a desired level of solvency and set of risk parameters.”

However, outcome-oriented or self-centric measurement of performance often disappears at the asset level, where broad market benchmarks are still commonly used as reference points. As Aon Hewitt senior partner John Belgrove puts it: “To know if a manager is doing a good job, you need a benchmark that is representative of their opportunity set to judge them against. Undeniably cap-weighted benchmarks are the dominant form of investment measurement in the market. They are a fair and full representation of the opportunity set of a market and still the purest form of beta.”

In this context, benchmarks and indices serve a number of purposes to investors. As well as being representative of the performance across a given universe of securities (i.e. the money-weighted current opinion of value), they do not require rebalancing or transaction costs to maintain.

“They are one of the very best capital market innovations of the last 40 years,” according to Bob Maynard, chief investment officer of the $15bn Public Employee Retirement System of Idaho (PERSI). “Kudos to Bill Fouse and Wells Fargo for making it happen. They are also the cheapest alternative to an active management or other investment approach, and thus are a measure of a basic value-add.”

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