In the investment world, benchmarks are essential when comparing fund performances across all asset classes, including equity, fixed income, etc. Creating benchmarks has been an evolving science. Finding a precise and accurate benchmark is a process that comes with its own challenges and a number of factors need to be carefully considered before selecting the one that will work for you.
What makes for a good benchmark?
Unambiguous: The benchmark’s methodology and constituents should be transparent and readily available. The way a benchmark is constructed should also be available and known to all.
Investable: It should allow the investor to cease active management and just hold all its constituent securities. This means that the benchmark’s constituents should be liquid and accessible, allowing for a fully replicable implementation of the investment strategy.
Measurable: The benchmark should allow for returns to be easily calculable and on a reasonable frequency. The methodology should be so transparent that its performance over the horizon is calculable.
Relevance: The benchmark should be relevant to the investor’s investment objectives. It should ideally bear a close resemblance to the underlying strategy. For example, if a fund is thematic and invests in Infrastructure, it is irrelevant to have a Banking Index as the benchmark or a mid-cap fund with Nifty 100 as the benchmark.
Reflective of investment opinion: Managers have current investment knowledge, regardless of whether the knowledge is positive, negative, or neutral, of the securities, or they can factor exposures within the benchmark.
Transparency and stability: It should be specified in advance and before the start of an evaluation period, and its calculation methodology should be known to all parties. A good benchmark should also remain stable and consistent over time, with minimal changes to its composition or methodology.
Owned: Managers should be aware of the strengths and weaknesses of the benchmarks they have been asked to be judged against. With this benchmark, managers need to accept accountability for their client’s portfolio and be prepared to explain any variance. All in all, managers should be fully aware of the benchmarks they are being measured against, and it should be in line with their strategy and fully acceptable to them.
While mutual funds have a standardized approach and are well-regulated, it gets tricky when we look at PMS as a space. While most PMS managers offer a distinct style bias, they are categorized as a standard all-cap equity fund. This makes them distinct from mutual funds. A broader market index, however, will not do justice if chosen as a benchmark in this case. In want of an evolution in the benchmarking space, most end up choosing a broader benchmark. Ideally, this needs a nuanced understanding of style at the allocator or investor level, and only then, a curated index reflective of their style, owned by the PMS manager, be chosen.
However, the Association of Portfolio Managers in India (APMI) in its recent circular asked PMS firms to choose one out of three pre-fixed benchmarks for each of the asset classes, irrespective of the strategy (be it large, flexi, mid or small cap) applicable. The members and non-members did react initially, as rightly, the pre-fixed BMs are not owned by the PMS Manager. Especially for someone who has a longer track record, changing a benchmark needs to have valid reasoning, and that’s fair practice.
Even the globally accepted, GIPS guidelines are clear on this and ask for fair representation and full disclosures. For example, the old benchmark needs to be declared along with the new one for a minimum of one year and for as long as the disclosures are relevant to interpreting the track record.
A firm may not be GIPS-verified, and most in India are not. It is still a fair practice, which has merit, to allow both old and new benchmarks. After some further discussion and feedback, the association agreed to do so and allowed firms to show past performance until 31 March with both benchmarks for the next 36 months. This announcement finally provides some clarity and is totally in line with fair practices followed elsewhere. A better idea would have been to have both, a statuary or industry-wide benchmark and a portfolio manager owned benchmark.
While benchmarks play an important role for asset owners and investors, it’s evident that none are likely to be a perfect match for a client. It is obvious that a benchmark that is not derived based on an investor’s objective would lead to the wrong risk-return attribution. Thus, what matters is how well the benchmark fits the investor’s objective.
In summation, regulatory interest in benchmarks and indices suggests that Benchmarking as a concept needs continuous debate and evolution in order to fulfil its purpose effectively.
Pramod Dwidevi is co-head, business development, Karma Capital.
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Updated: 19 Jul 2023, 10:43 PM IST