Will transparency increase or will new rules hit roadblocks?
Beating the benchmark is the shared goal of most fund managers, and comparing a manager’s track record with their benchmark tends to be the way we assess performance.
But is benchmarking the best way to measure a fund’s success and the manager’s value?
Earlier this month, the FCA published guidelines around benchmarking, following last year’s probe into the asset management market. The regulator asked managers who use benchmarking to justify why that particular benchmark is appropriate for their fund, and for those managers who don’t use a benchmark, to justify why they did not.
The rules aim to increase transparency and improve communication. Experts remain divided, however, on whether they will improve the quality and reliability of benchmarks for investors.
Comparing apples and oranges
Morningstar’s global data director Andy Pettit believes the regulator’s instructions are a step in the right direction.
He says: “Clarity about what benchmark the fund is using, and showing it persistently across all fund documentation, takes away potential confusion of a fund being compared against one benchmark in one place and another benchmark in another place.
“As it stands at the moment, funds might potentially have a target [benchmark] and a comparator and a constraint, but only show one of them in one document and another one in a different document, so I think levelling that playing field and making it more transparent is definitely a good step forward.”
Apart from sticking to the same benchmark across the funds’ documentation, fund managers are now being asked to reason their choice of benchmark. This requirement could prevent a fund manager advertising an unfitting benchmark to make their fund’s performance look better.
Last year, a study from the University of Arkansas looked at “benchmark discrepancies of mutual funds” – or the instances where the researchers concluded that the benchmark chosen by the manager was not the most suitable one for that fund’s investment style.
The conclusion was that funds with discrepancies were generally riskier, and therefore tended to outperform their apparent peers before risk-adjusting. The same funds generally underperformed their actual peers, however.
Shore Financial Planning director Ben Yearsley says he double-checks the appropriateness of the given benchmark during his due diligence routine.
Yearsley says: “I don’t think fund managers’ chosen benchmarks are always right, so it is interesting that the FCA wants managers to justify their choice.
“I always try to compare funds with similar funds and appropriate benchmarks. What it will hopefully stop managers doing is comparing themselves to something that is easy to beat, meaning they always look good.”
Pettit also recommends looking at a fund’s peers, even in the absence of self-assigned benchmarks.
Pettit says: “If a fund has a global mandate, it suggests looking at its performance against the global benchmark, even if the fund is not benchmarked to it.”
Pettit adds Morningstar finds its own representative benchmark for every fund category as a baseline for comparison and statistics.
Choosing a representative benchmark for each fund category is a provider-agnostic process, where Morningstar’s researchers, who are familiar with individual fund category definitions and individual benchmarks available on the market, choose the best match.
Chelsea Financial Services managing director Darius McDermott says that using a competitor fund as a benchmark can be a useful alternative, particularly where funds have a similar investment style.
He says: “You might have two deep-value funds which have underperformed the market. This might be understandable if it is because their style has been out of favour, but you can still see which of the two funds has done better.”
McDermott warns against using only one competitor fund as “a permanent benchmark”.
He says: “I would always try to look at a full range of competitor funds, as well as the performance of the market, and performance of different styles and market caps within the market, to get the fullest picture.
“We will sometimes build a composite benchmark to account for the fund’s size and style biases.
“In this way, we can more easily measure the fund’s true out- or under-performance from stock selection.”
According to SCM director Alan Miller, while having a benchmark is commonplace, it might not always be the best way to access each and every fund’s performance.
He says: “It is better to comprehend the strategy, costs and risks to assess the return rather than purely look at a benchmark, which may have little relevance.”
Darren Cooke, director at Red Circle Financial Planning
Benchmarking is a good way of measuring performance, provided that it is appropriate to the fund, or the portfolio. Fund performance can be assessed against other funds in that sector. For portfolios, you either have to use a risk-based approach and choose a benchmark that is appropriate based on overall risk of that portfolio, or you can use an asset mix – if the portfolio has 60 per cent global equities, 40 per cent bonds, you’d benchmark off that.
With funds, the benchmark is that of a sector; a UK equity fund, which will be benchmarked against the UK equity sector, so that’s relatively straightforward. With mixed asset it could be a little more tricky. You might want to have a look under the bonnet of what that fund actually holds and measure it against the appropriate sector.
Getting the communication clear
In the case of funds that are not aiming to beat a benchmark, the FCA is also looking to ensure that investors understand what the fund is trying to do and how good a job it is doing in achieving it.
In the past, there were instances of miscommunication around providers’ labels for products lacking benchmarks.
In November 2017, Seven Investment Management rebranded its Unconstrained fund to a Real Return fund, acting on the feedback it had received from advisers.
The consensus was that the word Unconstrained raised red flags among planners, inferring it was a higher-risk product than was actually the case.
7IM did not comment on whether it continues to monitor adviser sentiment or whether it is considering changing communication around the funds’ target in the wake of the FCA’s recommendations.
Pimco, which also recently switched the term “unconstrained” for “dynamic” on one of its bond funds, declined to comment on further changes to the language that it uses.
Can you benchmark risk?
As the results of the benchmark discrepancy study showed, not taking risk into account gives a misleading impression of a fund against a benchmark.
MSCI teamed up with risk-profiling provider Dynamic Planner last week to create a tool to compare a fund’s performance against Dynamic Planner’s risk-profile allocations.
Dynamic Planner head of proposition Chris Jones says that users will be able to go 13 years back and see what the particular asset allocation would have delivered.
He says: “Where asset managers weigh their decisions around going underweight and overweight somewhere else, or achieve alpha from block selection, they will be able to show that as relative to our standard asset allocation.
“You will be able to see in a clear way what the fund manager delivered for his money.”
Jones believes traditional fund performance indices, or comparisons with cash or inflation, could mislead investors.
He says: “Comparing a sensible fund against FTSE 100 or MSCI World in the past 10 years, when the markets were doing really well, didn’t make it look like you were doing particularly well, which wasn’t great for the client, because it encouraged them to take more risks.
“Now people are seeing markets go down and thinking their fund is going down against cash, when what they should be looking at is how much it is going down compared to the right asset allocation risk profile.”
The importance of having the right benchmark
Darius McDermott, managing director at Chelsea Financial Services and FundCalibre
To get a bit technical: generally, the higher the R-squared (or coefficient of determination) of the benchmark to the fund, the more appropriate the benchmark is. This basically shows how closely the two data sets explain one another. I would argue best practice is to understand any inherent style and size biases in a fund and select an appropriate benchmark accordingly.
Having the wrong benchmark could lead you to the wrong conclusion about a fund’s performance. It might cause you to sell a fund which is actually outperforming.
Another big danger with most benchmarks is they do not account for risk.
In conventional financial theory, risk and return are indivisible. This is a major danger of relying too heavily on benchmarks. It may be that a manager has slightly underperformed their benchmark, but has done so with half the risk. In this case they are likely to be a very good manager.
Conversely, a manager who has only slightly outperformed but has done so with twice the risk is probably not very good. This is why it is always important to look at funds on a risk-adjusted basis, as well as just looking at performance versus a benchmark.
For some more complex funds it may be that there is genuinely no comparable benchmark. In these cases managers will generally give a cash-plus target as a way of measuring their performance.
As long as this target is clearly communicated and explained, that is reasonable.
Most funds already have a very clear benchmark, so in most cases I don’t think this will be much of an issue. In the few cases where the benchmark is not clear, this may help to improve transparency and communication.
Finally, I would caution against over-obsession with a fund’s performance versus its benchmark. While measuring performance is important, it is equally important to understand the underlying fund and why it might have under or outperformed.
Is performance down to genuine stock selection or have other factors helped or hurt it?
We should remember that all funds will have periods of under-performance.