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Is Your Benchmark Right For Your Strategy And Performance Measurement?

Nov. 18, 2015

Nov. 18, 2015

There has been a vast shift in asset owners’ attitudes to passive investing in recent years. Active management was once the default choice, but with greater transparency into managers’ fee structures, investors are realizing that many managers charge too much for returns and thus they are better off using passive and systematic solutions. Regulation is also playing a role in the shift with new rules enacted earlier this year restricting management fees in defined contribution auto-enrollment pension schemes.

‘Passive investing’ does not mean, however, an entirely passive approach. There are certain rules of the game that asset owners should not overlook. Selecting the right benchmark or set of benchmarks for passive mandates is the top of that list. PULSE ONLINE spoke with Muhammad Ashar, Global Asset Owners and Consultant Relations at STOXX Limited, who named two main pitfalls in selecting passive benchmarks:

- Maintaining the status quo by defaulting into a benchmark

- Taking a one-size-fits-all approach.

The danger of maintaining the status quo

Benchmarks play a crucial role when they serve as ‘underlyings’, i.e. when they underpin an investment strategy, as well as when they are purely used to measure the performance of a portfolio. This is the main reason that asset owners must be sure that the benchmarks they use are relevant to the objectives of the mandate. This requires actively considering options when selecting a benchmark, rather than defaulting to the status quo. Ashar has observed that while many investors are allocating an increasingly larger portion of their portfolio to passive investments, they do not consistently spend a corresponding amount of time evaluating the benchmarks.

“Many investors choose market-cap indices – either because their peers use them, or for legacy reasons. They effectively maintain a status quo when it comes to benchmarking passive investment strategies. However, that doesn’t mean they are the right choice for all investors,” says Ashar. “Choosing a benchmark for a particular passive strategy should be a conscious decision, not a default one.”

One size does not fit all

The other pitfall arises when investors take a one-size-fits-all approach to benchmarking, which can have an adverse effect on their ability to achieve efficient investment outcomes. Ashar illustrated his point by looking at two scenarios, one concerned with volatility, and the other with targeted investment strategies:

- Equity strategies focused on risk gained traction in the wake of the global financial crisis, and in the recent volatility in equity markets. In this environment, risk-averse investors poured assets into low-volatility smart-beta strategies or active strategies claiming superior risk-adjusted returns. However, academic research and a growing body of empirical evidence indicate that the objectives of risk-aware and risk-averse investors are better captured by minimum-variance frameworks. The STOXX Minimum Variance indices provide strong historical total returns and even better risk-adjusted returns.

- Investors with strong positive views about the Eurozone economy could invest thematically to capture these views. If the chosen benchmark is a standard regional equity index which selects companies based on their country of incorporation, however, the portfolio would have significant exposures to overseas markets. If the goal is to capture pure exposure to the Eurozone, a better benchmark would be a EURO STOXX True Exposure™ (STOXX TRU™) index which selects companies not simply based on their country of incorporation but also according to their revenue exposure to the Eurozone.

Different objectives require different benchmarks

Whether using active or passive mandates, asset owners need to find a reliable way to measure performance objectives, and this requires careful benchmark selection. Deciding on an investment strategy is vital, but deciding on the right benchmark for your investments is an equally important part of the process that should not be overlooked. Simply maintaining the status quo or taking a one-size-fits-all approach will leave asset owners open to the risk of not fulfilling their responsibility to their members.

 

 

Please share your feedback, comments or questions by sending an email to our editors at pulse@stoxx.com.

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