Benchmarking Policy Portfolios <strong>How</strong> best <strong>to</strong> benchmark asset allocation decisions By <strong>David</strong> Krein 18 July/August 2009
Investment performance cannot be measured without a benchmark. A good benchmark should be unambiguous, investable, measurable, appropriate, reflective of current investment opinions <strong>and</strong> specified in advance. 1 Certain indexes serve as good benchmarks because they are <strong>to</strong>ols designed <strong>to</strong> measure the performance of a particular market over time without any unnecessary or unreasonable biases. This article examines benchmarking issues in both single <strong>and</strong> multi-asset class portfolios. One Small Step … Within a policy portfolio, single asset class benchmarking is accomplished using widely accepted methods <strong>and</strong> procedures. A benchmark, though, is not relevant on its own; it must coexist with an investment in an asset class. In practice, such an investment will typically be assigned <strong>to</strong> one or more asset managers who will, in turn, each be given a m<strong>and</strong>atespecific benchmark <strong>to</strong> gauge their performance. The m<strong>and</strong>ates themselves are often narrower than the asset class, such as large-cap growth or small-cap value in the equity space. Any m<strong>and</strong>ate narrower than the asset class should identify the appropriate subasset class benchmark along with corresponding weight, specified in advance. 2 Otherwise, the risk of benchmark misfit is significant. Benchmark misfit is an investment decision that leads <strong>to</strong> uncompensated risk. Prudent inves<strong>to</strong>rs do not take uncompensated risks because they do not receive additional return for doing so. Therefore, benchmark misfit needs <strong>to</strong> be properly measured <strong>and</strong> moni<strong>to</strong>red. Benchmark misfit is calculated as the difference between the return of the asset class benchmark <strong>and</strong> the weighted average return of all benchmark m<strong>and</strong>ates assigned <strong>to</strong> individual asset managers. In other words, misfit exists when the sum of Figure 1 the assigned parts does not equal the desired whole. Benchmark misfit can be decomposed in<strong>to</strong> two categories: (1) gaps <strong>and</strong> overlaps; <strong>and</strong> (2) allocation misfit. Misfit #1: Gaps And Overlaps Gaps <strong>and</strong> overlaps occur when the subasset class benchmarks are mixed <strong>and</strong> matched among different index providers. For example, many in the investment community use the S&P 500 Index <strong>and</strong> the Russell 2000 Index as the st<strong>and</strong>ard benchmarks for large-cap <strong>and</strong> small-cap domestic equities, respectively. Figure 1 illustrates an example of the gaps in market coverage when the large-cap <strong>and</strong> small-cap benchmarks are set <strong>to</strong> the S&P 500 Index <strong>and</strong> Russell 2000 Index. The asset class benchmark has been set <strong>to</strong> the Dow Jones U.S. Total S<strong>to</strong>ck Market Index, which covers the entire opportunity set of all U.S. equity securities with readily available prices. As of Jan. 1, 2009, the gap in market coverage of the S&P 500–Russell 2000 combination results in 2,165 missing constituents, which is nearly half of all available constituents. This equity gap leaves over $1 trillion, or 11 percent, of the U.S. s<strong>to</strong>ck market unaccounted for. The median market capitalization of the missing 2,165 s<strong>to</strong>cks is $28 million, <strong>and</strong> the median market capitalization of the <strong>to</strong>p quartile of those s<strong>to</strong>cks is $1.51 billion, <strong>and</strong> includes such names as Genentech ($38.44 billion), Visa ($22.53 billion) <strong>and</strong> Accenture ($18.03 billion). No reasonable inves<strong>to</strong>r should use a benchmark that excludes the <strong>to</strong>p 11 percent of the U.S. equity market, the bot<strong>to</strong>m 11 percent or any other 11 percent. Misfit #2: Allocation Misfit Allocation misfit exists when asset allocations deviate from the actual market coverage of the asset class benchmark. Figure 2 illustrates an example of allocation misfit. A hypothetical Gaps In Market Coverage Benchmark Constituents Market Cap ($ Billion) Market Coverage Dow Jones U.S. Total S<strong>to</strong>ck Market Index 4,599 9,662.04 100.00% S&P 500 Index 500 7,851.81 81.26% Russell 2000 Index 1,934 745.35 7.71% S&P 500 + Russell 2000 Sub<strong>to</strong>tal 2,434 8,597.16 88.98% Gap in Market Coverage 2,165 1,064.88 11.02% Source: Dow Jones Indexes, iShares fund fact sheets Figure 2 Allocation Misfit Benchmark Subasset Class Allocation Actual Benchmark Coverage Quarter Ending March 31, 2009 Dow Jones U.S. Large-Cap Total S<strong>to</strong>ck Market Index 85.00% 88.25% -10.32% Dow Jones U.S. Small-Cap Total S<strong>to</strong>ck Market Index 15.00% 10.68% -12.42% Dow Jones U.S. Micro-Cap Total S<strong>to</strong>ck Market Index 0.00% 1.06% -10.06% Weighted Average Benchmark Performance -10.56% -10.63% Benchmark Misfit Impact -0.07% Source: Dow Jones Indexes www.journalofindexes.com July/August 2009 19
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