Benchmarking basics: A fiduciary perspective 

To assist fiduciaries in answering the important question of “How are we doing?” this paper will address:

• How fiduciaries should use benchmarks
• Common types of benchmarks used for evaluation
• Constructing benchmarks at the total portfolio level

What are benchmarks and how should fiduciaries use them?

A benchmark is a measurement tool that provides a reference point for determining the success of an investment strategy and to confirm achievement of a goal. We’ll explore three types of benchmarks that can be useful at both the individual manager level and at the total portfolio level – Market Indices, Peer Groups, and Absolute Return Indices. The use of benchmarks as reference points helps you assess precisely ‘how you’re doing’ versus the market, versus your peers, and versus your goals. And they support you in your obligation to monitor and evaluate performance. At the manager level, benchmarks serve as standards for measuring the value generated by active money managers. At the total portfolio level, they allow fiduciaries to understand how your investment program is doing relative to the established goals and mission of the organization and to help determine if you’re making good decisions. Investment committees may meet as often as quarterly to review portfolio and performance results. Given this frequency, it’s easy to focus in on short-term periods of relative performance versus a benchmark—a tendency which may lead to poor decision making. By nature, institutions generally have a long-term time horizon, often in perpetuity, which aligns with a longer-term performance evaluation period. So, decisions should be made based on a full market cycle of 5 years or more.

Asset class benchmarks and market indices

Traditional asset classes commonly use market indices as benchmarks. A market index is a reference portfolio of securities that’s used to measure the value of a particular market. There are a wide variety of indices available to track equity and fixed income asset classes across market capitalizations, styles and sectors. As performance evaluation benchmarks, market indices are ideal because data is widely available and relatively easy to understand—despite the fact that there are dozens of indices that can be used to evaluate the performance of any given investment. Common index providers include MSCI, known for global equity markets; Russell, known for U.S. equity market and style sub-sets; and Bloomberg Barclays, covering fixed income sectors, among many others. Each of these providers has its own index construction methodology. Often, equity indices are constructed by a capitalization-weighted method (where the largest market cap company in an index comprises the largest weight of the index). Therefore, a large price move in the largest company in an index can have a dramatic effect on the index’s value on any given day. In contrast to traditional asset classes where there’s a broad array of investable market indices to choose from, benchmarking in the alternative investments space is much different. There are no market indices to track these strategies; thus, peer universes are used to construct benchmarks such as HFRI (Hedge Fund Research Indices) that reflect hedge fund managers in the HFR database. However, since many diversified hedge fund investments offer differing investment strategies, it can be challenging to identify an appropriate peer group that represents a specific strategy. In addition, hedge fund benchmarks are not investable and suffer from survivor bias as described below. All of these factors present challenges in selecting benchmarks for alternative strategies. According to the Research Foundation of CFA Institute, “the most informative assessment of investment performance occurs when the benchmark has certain basic properties” (see Characteristics of a good benchmark below):

Peer groups

At the manager level, peer universes reflect investment managers with similar investment objectives. These are useful when evaluating the relative merits of an active management strategy, providing another layer of context to index comparisons. Investors often try to gauge a manager’s skill by comparing their performance to that of a group of similar managers. Common manager peer universes include eVestment Alliance, Morningstar, and Lipper. Each has its own construction methodologies.

In evaluating total portfolio performance versus peer groups, there are many sub-sets of institutional peer groups available—community foundations, private foundations, charitable organizations, and endowments, to name just a few. These organizations often use peer group analysis to learn how the investment portfolios of similar organizations are performing and what they may be doing differently. This information may help improve investment outcomes and demonstrate to potential donors that you are prudent stewards of assets.

Many charitable organizations refer to the NACUBO Study of Endowments for peer universe data because of the detailed level of reporting it provides on asset allocation and investment performance. The data is widely publicized and is comprised of a large number of the nation’s endowments for institutions of higher learning (705 for FYE 2020) reporting return and asset allocation data segmented by asset size. Returns are also broken out by asset class and market size for more detailed comparisons.

Market benchmarks allow fiduciaries to evaluate how an investment program is doing relative to the overall market and judge how an external investment advisor or consultant’s recommendations are adding value. A simple market benchmark denotes the overall investment objective of the portfolio and is sometimes referred to as a ‘naïve benchmark.’ For a portfolio that’s comprised of roughly 70% equities and 30% fixed income, the benchmark may be 70% S&P 500 and 30% Bloomberg Barclays Aggregate. For a global portfolio, a more appropriate benchmark may be 70% MSCI ACWI and 30% Bloomberg Barclays Aggregate.

Alternatively, a more complex policy benchmark blends the strategic asset allocation targets from the IPS and includes the asset classes comprised in the portfolio. This is sometimes referred to as the policy portfolio. It provides the framework for measuring results relative to the risk-adjusted return objectives stated within the IPS. A well-diversified investment portfolio should meet your long-term risk/return objectives and is the result of asset allocation analysis which incorporates long-term strategic targets for each asset class based on capital market assumptions. Forward-looking capital market assumptions include expected risk and return, as well as correlation, and are integral to properly diversifying a portfolio to achieve maximum return given an acceptable level of risk. Once the strategic asset allocation targets are set, a policy benchmark can be created and incorporated into the IPS that blends the relevant indices with the strategic targets for each asset class.

The use of a properly constructed and clearly defined policy benchmark will allow you to view investment performance results in the correct, relative context and measure progress accordingly.

The following sample (Exhibit A – Portfolio Guidelines) illustrates how benchmarks can be incorporated into your IPS. The stated policy benchmark blends the broad asset class targets and their appropriate indices. This policy benchmark can be constructed to be more granular (if desired) and include sub-asset classes, such as high yield fixed income. In addition, the spending policy benchmark is included to represent the absolute return investment objective of a non-profit organization with a 5% spending policy. Finally, indices and peer groups are specified at the asset class level for performance measurement at the underlying manager level. You should consult your investment advisor to help construct a customized benchmark most appropriate for your investment program.

Conclusion

Benchmarks are a valuable tool in the performance evaluation process. To assist you in fulfilling your fiduciary obligation to monitor and evaluate performance, you should focus on measuring what matters:

• Establish and monitor relevant benchmarks to understand the trend of performance and how the portfolio is tracking to long-term targets.
• Don’t overemphasize the most recent monthly or quarterly data. Instead focus on a full market cycle of 5 years or more.
• Consider an absolute return policy benchmark, knowing that it may require a long market cycle to achieve.
• Consult peer group comparisons for greater perspective.

Measuring what matters and using a combination of benchmarks will likely give you the broadest and clearest perspective to answer the important question of “How are we doing?