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 Investment performance cannot be measured without a benchmark. A good benchmark should be unambiguous, investable, measurable, appropriate, reflective of current investment opinions and specified in advance.1 Certain indexes serve as good benchmarks because they are tools designed to measure the performance of a particular market over time without any unnecessary or unreasonable biases. This article examines benchmarking issues in both single and multi-asset class portfolios.
One Small Step …
Within a policy portfolio, single asset class benchmarking is accomplished using widely accepted methods and procedures. A benchmark, though, is not relevant on its own; it must coexist with an investment in an asset class. In practice, such an investment will typically be assigned to one or more asset managers who will, in turn, each be given a mandate-specific benchmark to gauge their performance. The mandates themselves are often narrower than the asset class, such as large-cap growth or small-cap value in the equity space. Any mandate narrower than the asset class should identify the appropriate subasset class benchmark along with corresponding weight, specified in advance.2 Otherwise, the risk of benchmark misfit is significant.
Benchmark misfit is an investment decision that leads to uncompensated risk. Prudent investors do not take uncompensated risks because they do not receive additional return for doing so. Therefore, benchmark misfit needs to be properly measured and monitored.
Benchmark misfit is calculated as the difference between the return of the asset class benchmark and the weighted average return of all benchmark mandates assigned to individual asset managers. In other words, misfit exists when the sum of the assigned parts does not equal the desired whole.
Benchmark misfit can be decomposed into two categories: (1) gaps and overlaps; and (2) allocation misfit.
Misfit #1: Gaps And Overlaps
Gaps and overlaps occur when the subasset class benchmarks are mixed and matched among different index providers. For example, many in the investment community use the S&P 500 Index and the Russell 2000 Index as the standard benchmarks for large-cap and small-cap domestic equities, respectively. Figure 1 illustrates an example of the gaps in market coverage when the large-cap and small-cap benchmarks are set to the S&P 500 Index and Russell 2000 Index. The asset class benchmark has been set to the Dow Jones U.S. Total Stock Market Index, which covers the entire opportunity set of all U.S. equity securities with readily available prices.
As of Jan. 1, 2009, the gap in market coverage of the S&P 500–Russell 2000 combination results in 2,165 missing constituents, which is nearly half of all available constituents. This equity gap leaves over $1 trillion, or 11 percent, of the U.S. stock market unaccounted for. The median market capitalization of the missing 2,165 stocks is $28 million, and the median market capitalization of the top quartile of those stocks is $1.51 billion, and includes such names as Genentech ($38.44 billion), Visa ($22.53 billion) and Accenture ($18.03 billion). No reasonable investor should use a benchmark that excludes the top 11 percent of the U.S. equity market, the bottom 11 percent or any other 11 percent.
Misfit #2: Allocation Misfit
Allocation misfit exists when asset allocations deviate from the actual market coverage of the asset class benchmark. Figure 2 illustrates an example of allocation misfit. A hypothetical investor has decided to benchmark 85 percent of their portfolio to the large-cap subasset class, 15 percent to small-caps and no exposure to micro-caps. The actual market coverage of the policy benchmark is listed as of Jan. 1, 2009. The result of these decisions (i.e., underweighting large-cap, overweighting small-cap and underweighting micro-caps) is approximately 9 basis points in benchmark misfit. Those 9 basis points represent a performance mismatch that can be directly attributed to the allocation decisions exclusive of manager performance.
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