How to Kill a Black Swan Remy Briand and David Owyong ...

investor has decided to benchmark 85 percent of their portfolio
to the large-cap subasset class, 15 percent to small-caps and
no exposure to micro-caps. The actual market coverage of the
policy benchmark is listed as of Jan. 1, 2009. The result of these
decisions (i.e., underweighting large-cap, overweighting smallcap
and underweighting micro-caps) is approximately 9 basis
points in benchmark misfit. Those 9 basis points represent a
performance mismatch that can be directly attributed to the
allocation decisions exclusive of manager performance.
Compounding The Problem
Figure 3 illustrates an example of the compounding effect of
the allocation misfit along with gaps in market coverage. Using
the benchmarks from Figure 1 and the subasset allocation decisions
from Figure 2, the result of these decisions (i.e., ignoring
~500 mid-caps and 1,665 micro-caps) is, after one year, approximately
104 basis points in benchmark misfit. Stated differently,
the decision to deviate from the actual market coverage of the
asset class benchmark has, in this case, “cost” the investor 104
basis points. Note that the decision is on the part of the investor,
who has responsibility for assigning the individual benchmarks
and weights. The misfit excludes any “alpha” which, whether
positive or negative, is generated by the aggregate decisions
made by the managers. This distinction is critical.
Achieving A Zero Misfit Portfolio
Figure 4 illustrates a comprehensive asset class benchmark.
The subasset class benchmarks and weights are specified
in advance and properly aligned with it.
Under this scenario, investment performance can be
directly attributed to each mandate decision without any
Figure 3
Source: Dow Jones Indexes, iShares fund fact sheets
Figure 4
Source: Dow Jones Indexes
Benchmark
Benchmark
Compounded Misfit
Subasset Class
Allocation
Comprehensive Asset-Class Benchmark
Subasset Class
Allocation
benchmark misfit. Any mandate that deviates from this baseline
opportunity set will then not allow an investor to properly
measure the impact of their own decisions on their own
portfolio for a given asset class. The benchmark misfit analysis
must precede—and remain separate from—the active
versus passive decision as well as the decisions on the part of
their selected managers in attempting to generate alpha.
The Cost Of Inappropriate Benchmarking
Benchmark misfit is an investment decision that leads to
uncompensated risk. Prudent investors do not take uncompensated
risks because they do not receive additional return
for doing so. Therefore, benchmark misfit needs to be properly
measured and monitored.
Using an inappropriate benchmark can result in misleading
information being provided to all parties involved in
the investment process. If a manager is outperforming the
assigned benchmark, which is not an appropriate benchmark,
an investor may believe the manager is successful, when in
fact they may be under-performing by a material amount. In
such cases, an investor may be paying for less-than-expected
performance. The investor has spent more and received less
while being led to believe by the benchmark misfit that the
manager is doing well.
This can also occur in more-subjective benchmark assignments,
especially when managers are ranked relative to a
peer group. Unfortunately, peer group analysis falls short
of being a good benchmark because the average is neither
investable nor specified in advance. Further, the peers may
actually be a poor proxy for the asset class or subasset
class. Finally, the practical implementation of gathering
peer group data of sufficient
scale and relevance is quite
complicated and often incorporates
significant biases.
Quarter Ending
March 31, 2009
S&P 500 Index 85% -11.01%
Russell 2000 Index 15% -14.95%
Weighted Average Benchmark Performance -11.60%
Asset Class Benchmark Performance -10.56%
Benchmark Misfit Impact -1.04%
Year Ending
Dec. 31, 2008
Dow Jones U.S. Large-Cap Total Stock Market Index 88.25% -10.32%
Dow Jones U.S. Small-Cap Total Stock Market Index 10.68% -12.42%
Dow Jones U.S. Micro-Cap Total Stock Market Index 1.06% -10.06%
Weighted Average Benchmark Performance -10.56%
Asset Class Benchmark Performance -10.56%
Benchmark Misfit Impact 0.00%
From One To Many
In practice, investors hold
more than just equities or
any single asset class in their
portfolios. They more typically
assemble a portfolio with a
number of diversifying asset
classes (even if just two).
However, benchmarking such
multi-asset class portfolios is
not a straightforward exercise
since it is not simply an
extension of the single asset
class approach. Although
the decision to use a given
benchmark in both single
and multi-asset class portfolios
may be driven by similar
purposes and mechanics, the
process for establishing a
multi-asset class benchmark
is fundamentally different
20
July/August 2009