Assume a portfolio manager focuses on large and liquid French stocks, but the performance is assessed against the Euronext 100 Index (a benchmark that includes stocks from multiple European countries, including the Netherlands, Belgium, Portugal, and Luxembourg).
Given Data:
- Portfolio return (P): 10%
- Euronext 100 Index return (Investor Benchmark, B): 9%
- CAC 40 Index return (Normal Portfolio, N): 12%
Analysis:
- Performance Against Investor Benchmark:
- Active return relative to the investor benchmark:
- Performance Against Normal Portfolio:
- True active return (portfolio vs. appropriate benchmark):
- This indicates underperformance relative to the most relevant benchmark (CAC 40), revealing that the manager did not add value.
Conclusion:
- The misfit active return is +1%+1\%+1%, derived from using the inappropriate Euronext 100 Index.
- The true active return is −2%-2\%−2%, showing underperformance against the correct CAC 40 Index benchmark.
Key Takeaways
- “Garbage in, garbage out”: Incorrect benchmarks lead to invalid conclusions about performance, hindering effective portfolio evaluation.
- Importance of a Proper Benchmark:
- It must reflect the investment process, style, and geographical focus of the manager.
- An accurate benchmark ensures that performance attribution identifies the real drivers of returns and distinguishes between skill and chance.
- Misfit Active Return: Highlights the discrepancy caused by benchmark misalignment, which can mask the manager’s true performance.
Selecting the correct benchmark is essential to maintain the integrity of performance evaluation and ensure that the insights derived are actionable and meaningful.
