When the owner of capital engages the services of professionals to manage that capital, an investment management agreement (IMA) should state an investment objective.Said IMA will also describe a benchmark against which the change in value of the capital may be compared to evaluate the ongoing progress of the manager in delivering the investment objective.
What makes for an appropriate benchmark? It goes without stating that the benchmark should correlate with the objective. Institutional equity mandates which are tightly defined in terms of region, sector or company size have been guided by four tenets, namely an appropriate benchmark is :-
- Composed of constituents that are known in advance of any valuation day
- Representative of the chosen asset class
While these requirements are suitable for single asset class benchmarking exercises and, by extension, permit a passive implementation option, we can draw on them when thinking about a benchmark for a multi-asset class portfolio.
The requirement for a benchmark to be constructed of constituents that are known in advance excludes the use of peer groups and allows for a full understanding of the risks being run in a given portfolio. It goes without saying that any yardstick must be measureable for it to be more than a vague notion of return. The investability of a benchmark is relevant for a strategy which can be implemented passively. This would be an important requirement if the objective is stated in terms of an asset class, for example “to deliver capital growth in excess of the return delivered from UK Equities”. However, where an investment objective is to deliver a prescribed return (such as a fixed integer or a margin above inflation, as examples) it highly unlikely that an investable passive option will exist.
Finally a benchmark is ideally representative of the opportunity set afforded to the investment manager by the investment management agreement. Here, a single asset class benchmark is easily defined, however where investment parameters offer little restriction in terms of asset class, geography or approach, then the construction of a composite benchmark becomes somewhat challenging and two risks become apparent: first, over-engineering a benchmark can be a distraction from the important job of ensuring the assets are managed appropriately: second, the more prescriptive the benchmark, the greater the risk that an agent will simply hug the benchmark in a passive manner.
For these reasons, as a multi-asset manager, we prescribe a CPI plus benchmark to portfolios. It sets a simple baseline objective: that portfolios should grow in real terms over time. This does not preclude the addition of other, more client specific targets but does at least allow an easy to understand and track measure of performance.