Market Indexes and Benchmarks

b. Describe investment uses of benchmarks; 1. *Reference points for segments of the SPONSOR 'S portfolio*; 2. Communication of instructions to the manager; 3. Communication of instructions to a board of directors and consultants; 4. Identification and evaluation of the current portfolio's risk exposures; 5. Interpretation of past performance and performance attribution; 6. Manager appraisal and selection; 7. Marketing of investment products; 8. Demonstration of compliance with regulations, laws, or standards.

*SPONSOR benchmarks* need to be distinguished from *FUND MANAGER benchmarks* A *sponsor's policy portfolio* is the *LONG-RUN allocation to asset classes* consistent with the sponsor's objectives and constraints From this, a *benchmark*, often in the form of an *investable MARKET INDEX*, will be specified for *each asset class* in the SAA That practice implicitly and reasonably specifies a *PASSIVE investment in the asset class as a NEUTRAL* comparison point in measuring *SPONSOR PROGRESS TOWARD INVESTMENT GOALS* By doing so, benchmarks are useful as *REFERENCE POINTS* for segments of the sponsor's portfolio

2. Distinguishing between a Benchmark and a Market Index Market Index

A *market index* represents the performance of a specified: 1. security market, 2. market segment 3. asset class* For example: The FTSE 100 Index Constructed to represent the broad performance of large-cap UK equities The *constituents of each of these indexes* are selected for their appropriateness in representing the targeted market, market segment, or asset class

Example when Market Index could also be used as a benchmark

A good example in which a market index is an *appropriate benchmark* is the case of *passive managers*, who typically invest in a portfolio similar (or identical) to a chosen market index so as to closely track its performance *An active US core equity manager* whose investment universe is the *S&P 500*—that is, one that seeks to add value by under- or overweighting component securities of the S&P 500—might also use the S&P 500 as its benchmark.

Liability Based Benchmarks (2)

A liability-based benchmark will *match the DURATION PROFILE* and other *KEY CHARACTERISTICS of the liabilities* A LIABILITY-BASED benchmark typically *consists of: 1. NOMINAL BONDS, 2. REAL RETURN BONDS 3. COMMONS SHARES

Case of when *Market Index could also be used as a benchmark*

A market index *may be considered for use as a benchmark*; however, the most appropriate benchmark or reference point for an investment manager *NEED NOT BE an *available market index*

b. Describe investment uses of benchmarks; 1. Reference points for segments of the SPONSOR 'S portfolio 2. Communication of instructions to the manager 3. Communication of instructions to a board of directors and consultants 4. Identification and evaluation of the current portfolio's risk exposures 5. *Interpretation of past performance and performance attribution* 6. Manager appraisal and selection 7. Marketing of investment products 8. Demonstration of compliance with regulations, laws, or standards

ATTRIBUTE & APPRAISE past performance and the consequences of the manager's investment decisions The benchmark helps the board and its consultants *determine and evaluate* the *manager's excess return* *Return attribution* identifies such things as whether the manager's security selection, industry bets, or yield curve positioning have added value What caused the manager's performance to be different from the benchmark's? Performance appraisal's chief focus is to distinguish active investment SKILL from *LUCK*

1. Absolute (including target) return benchmarks;

An absolute return benchmark is simply a *minimum target return* that the manager is expected to beat The return may be: 1.A stated minimum* (e.g., 9%), 2.Stated as a spread above a market index 3. Determined from actuarial assumptions An example: 30% per annum return for a PE investment Market *neutral long-short* equity funds are another example where absolute return benchmarks are used Because a market neutral fund is in principle a zero-expected systematic risk investment, the benchmark may be specified as a *three-month Treasury bill return*; the investment objective may be to *outperform the benchmark* consistently by a given number of basis points

Uses of indexes 1. Asset allocation proxies 2. *Investment management mandates* 3. Performance benchmarks 4. Portfolio analysis applications

As a result of their *effectiveness as asset allocation proxies*, *investment mandates* can include a specified benchmark index The benchmark index for a mandate communicates the expectations of the asset owner (e.g., plan sponsor) to the portfolio manager: The portfolio manager is generally expected to select securities primarily from the constituents of the index. Exceeding an index return is frequently considered an objective of an *actively managed portfolio* (and matching the index return is the objective of a *passively managed portfolio*) Such an *index* will be valid as an *evaluation tool*, of course, only to the extent that it *meets the criteria for a valid benchmark*

b. Describe investment uses of benchmarks; 1. Reference points for segments of the SPONSOR 'S portfolio 2. Communication of instructions to the manager 3. *Communication of instructions to a board of directors and consultants* 4. Identification and evaluation of the current portfolio's risk exposures 5. Interpretation of past performance and performance attribution 6. Manager appraisal and selection 7. Marketing of investment products 8. Demonstration of compliance with regulations, laws, or standards

Benchmark *communicates to the BOARD and EXTERNAL consultants the manager's AREA OF EXPERTISE and how a manager SHOULD INVEST and be EVALUATED* In a *multiple-manager fund*, benchmarks *convey the managers' coverage areas*, so that assets and securities that lack coverage or are overemphasized can be identified

b. Describe investment uses of benchmarks; 1. Reference points for segments of the SPONSOR 'S portfolio 2. Communication of instructions to the manager 3. Communication of instructions to a board of directors and consultants 4. Identification and evaluation of the current portfolio's risk exposures 5. Interpretation of past performance and performance attribution 6. Manager appraisal and selection 7. *Marketing of investment products* 8. Demonstration of compliance with regulations, laws, or standards

Benchmarks are also used to *MARKET INVESTMENT PRODUCTS* to potential investors The GIPS require that if a benchmark exists, it must be *included in a performance presentation* with its description If *no benchmark is provided*, a reason must be given Marketing requires the communication and explanation of the investment process, of which the *benchmark is an essential descriptor of the investment strategy* and a *crucial determinant of excess returns* *Excess returns* have been found to be a significant determinant of investor inflows, so the *choice of the benchmark* will influence the fund's ability to attract new capital

b. Describe investment uses of benchmarks; 1. Reference points for segments of the SPONSOR 'S portfolio 2. Communication of instructions to the manager 3. Communication of instructions to a board of directors and consultants 4. Identification and evaluation of the current portfolio's risk exposures 5. Interpretation of past performance and performance attribution 6. Manager appraisal and selection 7. Marketing of investment products 8. *Demonstration of compliance with regulations, laws, or standards*

Benchmarks are used to demonstrate compliance with regulations, laws, and standards *Regulatory organizations use benchmarks as part of their oversight and surveillance*, and as a result, benchmarks have become *mandated in many jurisdictions* In 1998, the US SEC introduced a requirement that mutual funds *self-designate a benchmark* and present their *historical returns alongside it in the prospectus* More generally, *institutions* are sometimes *restricted from investing in specific instruments*, such as below-investment-grade bonds Benchmarks for such institutions have to be *tailored* accordingly

b. Describe investment uses of benchmarks; 1. Reference points for segments of the SPONSOR 'S portfolio 2. Communication of instructions to the manager 3. Communication of instructions to a board of directors and consultants 4. Identification and evaluation of the current portfolio's risk exposures 5. Interpretation of past performance and performance attribution 6. *Manager appraisal and selection* 7. Marketing of investment products 8. Demonstration of compliance with regulations, laws, or standards

Benchmarks play a role in the *manager selection processes* because they *will influence the perception of a manager's skill* The analysis of past performance will involve a *qualitative assessment of whether the manager's investment process* is robust enough to produce *repeatable outperformance* in the future or, alternatively, whether a manager's *past underperformance* is likely to persist

2. Manager universes (peer groups);

Broad group of managers w similar investment disciplines Allow investors to make comparisons with the performance of other managers Managers are typically expected to beat the median manager return, which refers to the manager return that splits the sample of managers' returns in half Manager universes are *typically formed by asset class* & *the investment approach* within that class. *Hedge funds* are often evaluated relative to manager universe benchmarks, provided by such vendors as Credit Suisse/Tremont, Hedge Fund Research, and Lipper/TASS. *PE funds* are also commonly evaluated in this way; examples of data vendors are *Burgiss, Cambridge Associates, Preqin, and Thomson Venture Economics*

3. Broad market indexes;

Broad market indexes are measures of *broad asset class performance* Examples: *JP Morgan (EMBI)* for EM bonds *MSCI World Index* for global developed market equities Broad market indexes are *well known, readily available, and easily understood* *The number of market indexes* has proliferated over time so as to serve a greater number and variety of applications and end users The performance of broad market indexes is *widely reported in popular media* (television)

7. Custom security-based (strategy)

Custom security-based benchmarks are *built to accurately reflect the investment discipline of a particular investment manager* Such benchmarks are *developed through discussions with the manager* and an *analysis of past portfolio exposures* After the manager's investment process is identified, the benchmark is constructed by *selecting securities and weightings consistent with that process and client restrictions* A *cash weight* is also identified that is appropriate for the situation The benchmark is *subsequently rebalanced* on a *periodic basis* to ensure that it stays consistent with the manager's investment practice Custom security-based benchmarks are also referred to as *strategy benchmarks* because they should reflect the manager's particular strategy Custom security-based benchmarks are *particularly appropriate* when the *manager's strategy cannot be closely matched to a broad market index or style index*

5. Factor-model-based benchmarks;

Factor-model-based benchmarks are constructed by *examining the portfolio's sensitivity to a set of factors* Examples of factors include: 1 *the return for a broad market index*, 2. *company earnings growth*, 3. *industry*, and 4. *financial leverage* The simplest form of a factor-model-based benchmark is the *market model*, in which there is a *single factor*, the *return on a broad market index*

2. Distinguishing between a Benchmark and a Market Index Benchmark

However, many *active managers* follow *specific investment disciplines* that *CANNOT BE ADEQUATELY DESCRIBED BY A SECURITY MARKET INDEX* *BENCHMARKS* must be *appropriate for the SPECIFIC INVESTOR (SPONSOR)* and *any investment manager hired to manage money*, whereas *MARKET INDEXES* are typically meant to serve the *GENERAL PUBLIC'S PURPOSES* and *TO HAVE BROAD APPEAL*

Liability Based Benchmarks (3)

In a liability-based benchmark *component weights* are *determined based on the requirement that the benchmark closely track returns to the liabilities* *Investment success* relative to such a benchmark is linked with *achieving the objective of funding liabilities*; by contrast *outperformance of a market index* used as a *benchmark* would *not imply anything about the portfolio's ability to fund liabilities*

Uses of indexes 1. Asset allocation proxies 2. Investment management mandates 3. Performance benchmarks 4. *Portfolio analysis applications*

In addition to *benchmarking the manager's performance*, indexes can be used for more detailed portfolio analysis. For example, *currency-hedged* and *unhedged versions of non-domestic indexes* can be used to measure the effectiveness of a currency management strategy

Liability Based Benchmark Conclusion

In sum, in a liability-based benchmark, the benchmark is structured to *accurately reflect the return required to meet the future obligations* as well as *mimic the volatility of the liabilities* As an *additional benefit*, *MODELING THE LIABILITY risk exposure* will *help the MANAGER better understand the liabilities that must be satisfied* In conclusion, the *fund sponsor may select from a number of benchmarks, including BROAD market indexes*

Basis for investment vehicles

Indexes are also used as a *basis for investments*, such as *index mutual funds*, many *exchange-traded funds* (ETFs), and *derivatives*. Index funds, ETFs, and derivative instruments are created on the basis of indexes ranging in *breadth from broad markets* to *narrow market segments* and* investment themes*. *The royalties from licensing indexes* for such uses has been a major driver of the proliferation of market indexes. Derivative instruments, such as *futures and options*, are used in hedging, trading, and asset reallocation and have other uses as well. More recently, indexes have served as the basis for ETFs There is a great deal of research suggesting that it is difficult for active managers to earn their fees, so *passive investments in low-cost index funds* have become increasingly popular

Uses of indexes 1. Asset allocation proxies 2. Investment management mandates 3. *Performance benchmarks* 4. Portfolio analysis applications

Indexes are often used as *ex post performance benchmarks*, where they answer the basic question, *did the manager beat the market*? With the development of the CAPM in the 60s, the "market" index return representing the entirety of assets became important in investment theory. Investment practitioners subsequently looked to various *indexes* as proxies of this *market* return. The same *benchmark* validity criteria apply Sometimes, a combination of *more than one index* is used to create a *benchmark for the manager*, under the assumption that the manager's portfolio cannot be captured by a single index

Liability Based Benchmarks

LIABILITY-BASED BENCHMARKS are particularly important for investors who invest with the chief objective of providing for the *payment of a stream of liabilities* Examples:Insurance companies & defined benefit pension schemes Investing assets using a liability-relative approach, *assets are chosen for their ability to fund the payment of liabilities with relatively low risk* An appropriate benchmark for such an investor must *accurately represent changes in the value of the LIABILITY stream and thus be LIABILITY-based*

b. Describe investment uses of benchmarks; 1. Reference points for segments of the SPONSOR 'S portfolio 2. Communication of instructions to the manager 3. Communication of instructions to a board of directors and consultants 4. *Identification and evaluation of the current portfolio's risk exposures* 5. Interpretation of past performance and performance attribution 6. Manager appraisal and selection 7. Marketing of investment products 8. Demonstration of compliance with regulations, laws, or standards

Managers often describe themselves as *VALUE MANAGERS* or *GROWTH MANAGERS* However, these terms are *imprecise* An *appropriate benchmark* will have *RISK SIMILAR to the portfolio* and *be informative* in revealing the manager's *active risk exposures*, which should help explain the manager's performance within his chosen investment style

4. Style indexes;

Market indexes have also been more narrowly defined to *represent investment styles* within asset classes, resulting in style indexes Researchers found that stock valuation and market capitalization explained much of stock return variation In response, *many index providers* provided various *style versions* of their broad market indexes Wilshire introduced *value*, *growth*, and *size* subsets of its US Wilshire 5000 Index *Style indexes* are formed under the belief that a *characteristic of an asset*, such as a *stock's dividend yield* or a *bond's credit rating*, will be the *primary determinant of its subsequent performance*

Gauge of market sentiment

Possibly the most common use of indexes is as a *gauge of public or market sentiment* They answer the question, *how did the market do today*? *Index values* are cited incessantly in business media as an indicator of daily (and even intra-day) market movements. Such movements are *influenced by a wide variety of factors*, such as the *prospects for economic expansion* or recession, *war and rumors of war*, and *general feelings of investor confidence* *Market indexes* provide a convenient *summary statistic of expectations because they are succinctly summarized in a single number*, the *current return on the index* Market indexes convey the perceived importance of both past events and the probability of future events

6. Returns-based (Sharpe style analysis) benchmarks;

Returns-based benchmarks (Sharpe style analysis) are *similar to factor-model-based benchmarks* in that portfolio returns are *related to a set of factors* that do well in explaining portfolio returns. In the case of returns-based benchmarks, however, the *factors are the returns for various style indexes*: 1. *small-cap value* 2. *small-cap growth* 3. *large-cap value* 4. *large-cap growth*

3.2. Types of Benchmarks

The *seven* types of benchmarks 1. Absolute (including target) return benchmarks; 2. Manager universes (peer groups); 3. Broad market indexes; 4. Style indexes; 5. Factor-model-based benchmarks; 6. Returns-based (Sharpe style analysis) benchmarks; 7. Custom security-based (strategy) In addition, we discuss *liability-based benchmarks* which represent characteristics of a *stream of liabilities* rather than *A MARKET* or *MARKET SEGMENT* as do BROAD MARKET and STYLE INDEXES

6. Returns-based (Sharpe style analysis) benchmarks; Continued

The analysis produces a benchmark that is essentially the *weighted average of these asset class indexes* that *best explains* or *tracks the portfolio's returns* *The difference* between the use of the *style indexes* previously discussed and *returns-based benchmarks* is that the returns-based benchmarks *views style on a continuum*; for example, a portfolio may be characterized as *60% small-cap value* and *40% small-cap growth* To create a returns-based benchmark using Sharpe style analysis, an *optimization procedure* is used in which the *portfolio's sensitivities* (analogous to the bk's in factor-model-based benchmarks) are forced to be *non-negative and sum to 1*

3. Benchmark Uses and Types 3.1. Benchmarks: Investment Uses b. Describe investment uses of benchmarks;

There are *several uses of BENCHMARKS* in investment practice, including the following: 1. *Reference points* for segments of the sponsor's portfolio; 2. *Communication of instructions* to the manager; 3. *Communication of instructions* to a *board of directors* (or any oversight group) and consultants; 4. *Identification and evaluation* of the current portfolio's *risk exposures*; 5. Interpretation of *past performance and performance attribution; 6. Manager *appraisal and selection*; 7. Marketing of investment products; and 8. demonstration of compliance with regulations, laws, or standards.

Basis for investment vehicles

There are also *enhanced-index managers*, who take *active bets away from the index* while also trying to limit their *deviation from the index's risk* For an index to be useful as the *basis for an investment vehicle*, it *must be one that an investor can replicate at low cost without much difficulty* In sum, indexes serve *many vital purposes for sponsors, managers, and investors at large* We next examine the *construction of indexes*

b. Describe investment uses of benchmarks; 1. Reference points for segments of the SPONSOR 'S portfolio; 2. *Communication of instructions to the manager*; 3. Communication of instructions to a board of directors and consultants; 4. Identification and evaluation of the current portfolio's risk exposures; 5. Interpretation of past performance and performance attribution; 6. Manager appraisal and selection; 7. Marketing of investment products; 8. Demonstration of compliance with regulations, laws, or standards.

They will *convey the sponsor's expectations* to the manager as to *how the fund assets will be invested* and *their expected risk and return* By conveying the *sponsor's expectations*, *BENCHMARKS PROVIDE accountability*, so that if a manager's security selection and subsequent performance frequently diverges far from the benchmark, it is *apparent that the manager's investment approach is inconsistent with the fund's stated investment discipline* Benchmarks ALSO *ENSURE A DEGREE OF FAIRNESS* in the sense that the MANAGER will not be held to STANDARDS that the fund's BOARD or consultants might arbitrarily IMPOSE

5. Factor-model-based benchmarks;

To determine the *factor sensitivities*, the portfolio's return is regressed against the factors believed to influence returns. The general form of a factor model: Equation (1) Rp = ap + b1F1 + b2F2 ... bkFk + εp *The sensitivities (bk)* are then used to predict the return the portfolio should provide for given values of the systematic risk factors; *A higher positive sensitivity* indicates greater positive exposure to a specified factor and higher expected return, holding all else equal The factors (F) represent values that are related to security values, such as *interest rates* For example, *interest rates* may be inversely related to security prices If interest rates unexpectedly rise, then security returns will fall by the amount determined by the security's sensitivity (bk) to interest rate changes

Uses of indexes 1. *Asset allocation proxies* 2. Investment management mandates 3. Performance benchmarks 4. Portfolio analysis applications

Used for asset allocation, an index constructed consistently over time provides the investor a tool to *measure asset class ex ante return, risk, and correlations* It allows investors to determine the *incremental expected return & risk* from adding a new asset to a portfolio These measurements can be used to *design an investment policy* suitable for different risk aversion levels

Valid Benchmark Requirements

VALID BENCHMARKS will be: UNAMBIGUOUS INVESTABLE MEASURABLE APPROPRIATE REFLECTIVE OF CURRENT INVESTMENT OPINIONS SPECIFIED IN ADVANCE AND ACCOUNTABLE ("OWNED")

4. Market Indexes Uses and Construction 4.1. Use of Market Indexes

We discuss the *uses of indexes* in the approximate order that a *PLAN SPONSOR* would encounter them in practice: As 1. Asset allocation proxies 2. Investment management mandates 3. Performance benchmarks 4. Portfolio analysis applications Additionally, we discuss the use of indexes as a gauge of market sentiment and as the basis for investment vehicles