Don’t Overlook Benchmarks by The Finance Professionals’ Post

Investors are presented with a barrage of marketing material from funds and? managers trying to raise capital, and? what all these reports have in common is ?that they all focus on performance. That? is not surprising considering the ?relatively large number of funds available with the few strategies being ?used, managers feel they can only?differentiate themselves through performance. Attend enough sales presentations and you will have heard how “my long-short equity strategy has consistently outperformed the market and that is why you need to invest with us.” By the way, the “Past performance is no indication of future results” is usually said with much less gusto.

This is not to disparage managers and funds alike but rather to help investors identify the good managers whose past performance is more than likely a good indication of their future performance. Although a thorough performance evaluation requires the skill set of a performance specialist, any investor can begin such an evaluation by questioning one simple and important component of the performance marketing material, which is the benchmark.

What Are We Missing

As a performance specialist, my first reaction to any performance report is to question it. This is not to say we should all have a mistrust of performance presentations but rather a curiosity as to how that performance was achieved. Unfortunately, much of this curiosity is suspended far too often for investors. Perhaps this is a reason why many of them just accept the benchmark as a fair comparison for the portfolio. There are different types of benchmarks, from market indices to custom security-based and knowing enough about them will help investors gain greater insight into the skill of the manager.

What about absolute return strategies? The decision not to have any “physical” benchmark does not mean that there was no benchmark choice. Establishing a target return still constitutes a benchmark choice. Taking it further, investors fail to ask some simple questions: Do the risk characteristics of the benchmark resemble that of the portfolio? Does the benchmark and fund cover the same portion of the market? Overall, is it really a fair comparison? Failure to ask these questions is analogous to a racing team deciding on a driver by comparing one in a Formula One car and the other in a Honda Accord. It sounds ridiculous but this is what happens in fund/manager choices.

What Are Quality Benchmarks

How can we improve the evaluation process? We can first begin with some basic understanding of what makes a good benchmark. A benchmark is usually some passive alternative that is used to evaluate the performance of a manager following a similar approach but with an active element. The CFA Institute lists the following seven important characteristics in defining a good benchmark[1]. They are:

  1. Unambiguous: The identities and weights of securities or factor exposures constituting the benchmark are clearly defined.
  2. Investable: It is possible to forgo active management and simply hold the benchmark.
  3. Measurable: The benchmark’s return is readily calculable on a reasonably frequent basis.
  4. Appropriate: The benchmark is consistent with the manager’s investment style or area of expertise.

See full article here.

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About the Author

Susan B Weiner, CFA, teaches a highly regarded blogging class tailored to the needs of financial planners, wealth managers, investment managers, and the marketing and communications staff that supports them. She has spoken about writing across the U.S. and Canada for the CFA Institute. Author of the Investment Writing blog, Weiner writes and edits articles, white papers, investment commentary, and other communications for leading investment and wealth management firms.

Don't Overlook Benchmarks

Financial Blogging: How to Write Powerful Posts That Attract Clients

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