Benchmarks play a critical role in evaluating investment performance. They provide a reference point to measure the success of an investment strategy, whether for liability-driven investing or asset-based approaches. Below, we explore the uses of liability-based benchmarks and various types of asset-based benchmarks in detail.
Liability-Based Benchmarks
Definition and Purpose:
Liability-based benchmarks are tailored for portfolios designed to meet specific liabilities, such as defined benefit pension plans. These benchmarks are structured around the cash flows required to satisfy future liabilities.
Key Features:
- Focused Asset Selection: Liability-based benchmarks often limit investment options to high-quality assets like nominal bonds, inflation-protected bonds, or stocks with minimal volatility.
- Custom Structure: The structure of the liabilities influences the choice of benchmark and portfolio assets.
Example Scenario:
Consider a defined benefit plan with liabilities tied to future pension payments. The investment benchmark and asset selection depend on factors such as:
- Time to retirement for active workers.
- Proportion of retired workers already drawing benefits.
- Sensitivity of liabilities to inflation.
- Correlation between company profits (EBIT) and plan assets.
- Plan characteristics (e.g., frozen plans or terminal plans).
- Actuarial assumptions like life expectancy and required discount rates.
Types of Asset-Based Benchmarks
Asset-based benchmarks are widely used to evaluate the performance of investment managers against a reference point. There are seven primary types of these benchmarks:
1. Absolute Benchmarks
Definition:
An absolute benchmark aims to achieve a specified return target, such as a minimum acceptable return (MAR) used in metrics like the Sortino ratio.
Advantages:
- Simple and easy to understand.
- Provides clarity for investors and managers.
Disadvantages:
- Not an investable benchmark, as it does not represent a real portfolio or market.
2. Broad Market Indexes
Definition:
Benchmarks based on widely recognized indexes, such as the S&P 500 for U.S. equities or MSCI World Index for global stocks.
Advantages:
- Well-recognized and understood by clients.
- Unambiguous, measurable, investable, and specified in advance.
- Appropriate for managers whose strategies align with the index.
Disadvantages:
- May not reflect the specific style or investment process of certain managers (e.g., using S&P 500 for a small-cap growth manager).
3. Style Indexes
Definition:
Benchmarks representing specific investment styles, such as large-cap growth, large-cap value, small-cap growth, or small-cap value indexes.
Advantages:
- Widely accepted and understood.
- Useful when aligned with the manager’s investment style.
Disadvantages:
- Overexposure to specific securities or sectors can lead to concentration risks.
- Differences in definitions of “style” can result in benchmark discrepancies.
4. Factor-Model-Based Benchmarks
Definition:
These benchmarks use mathematical models to relate portfolio returns to systematic risk factors (e.g., market exposure, size, value). A generalized equation is:
Advantages:
- Provides insights into a manager’s style and systematic exposures.
- Useful for performance evaluation.
Disadvantages:
- Complex and may not be intuitive.
- Requires access to data and modeling expertise.
- Results may vary based on the model used, leading to potential ambiguity.
5. Returns-Based Benchmarks
Definition:
These benchmarks are derived from the historical returns of the portfolio and style indexes over a specified period. Statistical methods estimate the combination of style indexes that best replicate the portfolio’s performance.
Advantages:
- Easy to use and intuitive.
- Effective when only portfolio returns are available.
Disadvantages:
- May not align with the portfolio’s actual holdings.
- Requires a sufficient number of return periods for accuracy.
- Ineffective for managers who frequently change investment styles.
6. Manager Universes
Definition:
Benchmarks based on the median performance of a peer group of managers with similar investment styles.
Advantages:
- Provides a measurable point of reference.
Disadvantages:
- Prone to survivor bias, as underperforming managers are removed from the universe.
- Not investable, as it is not predefined and depends on historical data.
- Reliant on the quality of the compiler’s data and representations.
7. Custom Security-Based Benchmarks
Definition:
Benchmarks tailored to reflect a manager’s actual security holdings and investment process.
Advantages:
- Fully customizable and aligns with the manager’s strategy.
- Allows detailed monitoring of manager performance.
- Meets all benchmark validity criteria.
Disadvantages:
- Expensive and time-consuming to construct.
- Requires transparency in the manager’s process, which may be challenging (e.g., for hedge funds).
Conclusion
Choosing the appropriate benchmark is crucial for measuring and evaluating investment performance effectively. While liability-based benchmarks focus on meeting specific future obligations, asset-based benchmarks provide diverse options tailored to the style, strategy, and goals of the portfolio. Managers must consider the advantages and limitations of each type to ensure alignment with their investment objectives and performance evaluation needs.
