View more on these topics

Sit on the benchmark

Do private investors need benchmarks with which to judge their fund manager&#39s performance?

The Committee of European Securities Regulators certainly thinks so. It has just published a conduct of business rulebook for all EU countries which is now with the Council of Ministers for adoption. It includes a requirement that every discretionary investment management agreement “must contain…the benchmark against which performance will be compared”.

However, many investors point to the way in which their investment manager uses the existence of a benchmark as justification for keeping clients heavily invested despite falling stockmarkets. Investors&#39 objective is to make money through stockmarket investment – not beat a benchmark if that simply means losing less money than the next man.

Every investor wants to make as much money as possible with as little risk as possible. What is the value of having a formal benchmark?

In the institutional investment management world, the benchmark is king.

The trustees of a pension fund may decide to invest a certain proportion of the fund in the stockmarket on a long-term basis and appoint one or more investment managers. Each manager is given a benchmark that will often be expressed as something like: “To beat the index by 1 per cent a year on a rolling three-year basis.” After three years, there is a review of performance and the manager will either have beaten the benchmark or not. If they have not, they will possibly be sacked. It is as simple as that.

There are three important features of this institutional model. First, the pension fund trustees take the decision to invest in the stockmarket, not the investment manager. The manager may adopt a defensive policy from time to time and move an element of the fund into cash but he will only do this at the margin. He is being benchmarked against the index so, if he comes out of the market in a big way and gets it wrong, he will lose any chance of beating the benchmark over the three-year period.

Since history shows that the stockmarket rises more often than it falls and since there are good reasons to expect this pattern to persist, there is more risk of underperformance in coming out of the market than staying in. Not surprisingly, the manager stays heavily invested all the time. This is the key element here. The trustees have decided to invest in the stockmarket and look to their investment manager to make the most of that decision by skilful investment on their behalf. They do not want him to come out of the market and undo their original decision to invest. If the market goes down, that is their fault, not his.

Therefore, they have set a benchmark which everyone understands implies that their manager will keep them heavily invested all the time. They may occasionally review their decision to be in the stockmarket to quite this extent and doubtless will invite their investment manager to contribute to and often lead that discussion. However, they do not want him to take that decision for them. The benchmark is a simple way of saying all this.

Second, the pension fund trustees are investing in the stockmarket on a long-term basis. Their liability to pay pensions stretches many years ahead so, provided they have ample liquidity to meet pensions already in payment, they can sit tight through difficult market conditions.

Third, a pension fund invests free of income and capital gains tax. The investment manager is free to choose whatever shares he wants to hold and to switch them whenever he chooses. In short, his performance is a true reflection of his investment judgements, uncontaminated by other factors.

It can be seen that there are a number of complications which arise when translating the use of benchmarks into the private investment context. The investor must recognise that, in setting a benchmark, they are in effect taking the core asset allocation decisions themselves. They must set a benchmark which captures their personal tolerance for risk and recognises the timescale over which funds can be locked away. They must recognise that tax considerations will almost certainly pollute the comparison with the benchmark to some degree, perhaps even invalidating it to a large extent. Certainly, the precision of the institutional index plus 1 per cent model will be lost.

So what of the accusation that benchmarks are used by investment managers as an excuse for staying heavily invested in falling markets? The charge is correct but misses the point. Most investors – and nearly all investment managers – long ago recognised that an investment policy based on being in the market when it is going up and out of the market when it is going down is inherently implausible. Most recognised long ago that shares go up more often than down. Therefore, they mutually agree benchmarks which will steel them to remain heavily invested, even in difficult conditions.

History, personal experience and future modelling all suggest that this will pay off in the end if client and manager keep their nerve. The benchmark helps them to do this.

Markets reward higher risks with higher returns. Take the risk and you will eventually get the return. An investment policy predicated on avoiding the risk but enjoying the return will fail. To set a benchmark is to recognise this and build it into your investment planning.

Recommended

Abbey makes investing Ea5y

Abbey National has introduced safety plus growth 9, a guaranteed equity bond that provides minimum growth of 20 per cent and maximum growth of 55 per cent.The bond is linked to the FTSE 100 index through a Dublin-based company called Quaich Investments 9 and there is also an Isa version of the product. Both versions […]

Medicare cover from £1 a week

Companies can give staff the employee benefit f healthcare for £1 a week under a scheme launched by Medicash this week.Medicash Reward covers all staff from 16 to 65 with benefits including cash payments for dental and optical treatment, on the birth or adoption of a child, for nights spent as an inpatient and consultants […]

A consumer&#39s view

It is difficult to know whether to be reassured or alarmed at the findings of the Tiner report on the regulation of the insurance industry. The revelation that life companies&#39 with-profits free-asset ratios had fallen to an average of 6.3 per cent by the end of last year – the lowest level since the present […]

JPMorgan shuffles team

JPMorgan Fleming is restructuring its European equities team of 40 after former head of European equities Andrew Spencer was appointed chief investment officer of JPMorgan Funds&#39 retail business in the US.Spencer will take up his new position in December. William Meadon, who has managed segregated funds for the European equities team over the past seven […]

Reforming India: just the beginning

By Kunal Desai, Neptune India Fund

As global investors continue to scour emerging markets through the lens of reform potential, India shines bright. Indeed, we think it can sparkle even brighter. We anticipate India’s self-imposed 10-year ‘policy holiday’ to turn into one of the most pro-growth and pro-investment policy calendars seen in Asia in years. The Indian electorate has engineered a historic verdict. We now have the strongest Indian government since 1984, with the pro-market Bharatiya Janata Party (BJP) achieving an absolute majority for the first time in the party’s history.

Newsletter

News and expert analysis straight to your inbox

Sign up

Comments

    Leave a comment