Time to Bench the Benchmark?

A look at the debate surrounding market indices and benchmarks as a meaningful reflection of clients’ goals and manager performance.

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Relative vs. Absolute Return Reporting

According to State Street’s Center for Applied Research, investors are moving away from benchmarking.

That was one of the key findings published in their 2012 study, “The Influential Investor: How Investor Behavior is Redefining Performance.” In the survey of over 3000 retail and institutional investors, asset managers, regulators and consultants, 44% of investors said they plan to move toward absolute return—and away from benchmarking—over the next 10 years, compared with 30% who will continue to focus on beating a benchmark.

Only time will tell whether absolute-return-based performance becomes the next gold standard, but one thing is clear: The industry is in the throes of a debate about whether—and how—benchmarks should be used. Over the next several months, we’ll take a look at various aspects of the debate and review some of the new performance tools gaining traction among managers and consultants. But first, here’s some context.

A response to turbulent markets

It’s no secret that recent periods of market volatility have given asset managers plenty of reasons to think beyond relative performance benchmarks based on cap-weighted indices. And standard attribution tools used to isolate a manager’s active contribution, such as Sharpe ratio, alpha, Information ratio and style drift, are being challenged by a cascade of newer models that purport to be more sensitive to downside risk and volatility. Enter Keating (2002) and Cascon, et. al.’s (2003) Omega Excess; the Sortino ratio; the Sturiale Consistency Ratio; low- and minimum-volatility benchmarks; and factor-bending “smart beta” indices.

Recent periods of market volatility have given asset managers plenty of reason to think beyond reletive performance benchmarks based on cap-weighted indices.Post Modern Portfolio Theory revisited

While the financial meltdown shocked the industry into revisiting how we define, dissect and measure performance, the underlying debate has its philosophical origins in the 1980s and the Post Modern Portfolio Theory movement.

Pioneered by Brian Rom, Dr. Frank Sortino and others, PMPT challenges some of the core assumptions underlying Modern Portfolio Theory. MPT assumes that all investors have a common objective: to maximize expected return for a given level of risk. In order to express levels of risk, MPT models rely on mean variance, using standard deviation above and below expected returns. The method assumes there is an upside and a downside risk to investing.

PMPT adherents reject those assumptions. They believe that investors do not share the same goal and, in fact, have different and highly specific investment objectives. What is important to them is achieving a rate of return that will accomplish their goal—be it funding a pension liability or generating retirement income. In the PMPT world, there is only one type of risk: the risk of not generating a return sufficient to achieve the investor’s goal. As a result, only returns below the target rate of return incur risk; returns above the target do not. Accordingly, PMPT models only recognize standard deviation below expected returns, aka semivariance, since downside risk is the only risk that investors care about.Post Modern Portfolio Theorists believe investors do not share the same goal and, in fact, have different and highly specific investment objectives.

Although relatively few asset managers have embraced Post Modern Portfolio Theory as the basis for their asset allocation and investment approach, many are using PMPT-based tools like the Sortino ratio to deconstruct and report on their performance. And PMPT’s philosophic belief in investor-specific return objectives is being reflected in the current resurgence of goals-based investing, personal performance benchmarks and an interest in absolute vs. relative returns.

Just so much quant candy?

While proponents of PMPT argue that their approach presents a more accurate picture of the relationship between risk, volatility and return, critics dismiss it as just more quant candy—tools that appeal to esoteric asset managers and high-priced consultants but add little real value to the process. According to Harry Markowitz, the father of mean variance analysis and MPT, “The mean variance approximation to expected utility is quite good. Going beyond that is not worth the extra fuss.”

Whether institutional investors embrace absolute return and/or gravitate toward the personalized, goals-based benchmarks now gaining traction in the wealth management sphere remains to be seen. One thing is certain, however. As long as global markets remain volatile and investors continue to face the possibility of catastrophic losses, the focus on downside risk will remain relevant. For active managers struggling to demonstrate value-added to their clients, the decision whether—and how—to benchmark could make all the difference.

Next month, we’ll focus on how some managers are using the concept of “active share” to identify the extent to which their portfolio holdings differ from the index-based benchmark.

Where is your firm in the debate?

Where does your firm stand on the issue of relative vs. absolute return reporting? Do you favor index-based benchmarks or peer-group benchmarks? Both? Neither? Can you see a way to move toward more client-oriented, goals-based benchmarks in your reporting?

We’d love to know where you stand in this debate. Please leave your comments, below.


 

[1] Duncan, Suzanne L., et. al. “The Influential Investor: How Investor Behavior is Redefining Performance.” State Street Center for Applied Research. 2012.

[2] Churchill, John. “Everything You Know About Asset Allocation Is Wrong.” WealthManagement.com. July 1, 2009.

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