Issue: June 2005
Baffled by benchmark buzz?
Choose your tools carefully
"Investment speak" is full of talk about benchmarks
that sometimes sounds confusing, but in fact their
purpose is actually very similar to benchmarks used in
real life. When we benchmark ourselves against
someone we are setting a standard or point of
reference against which we measure our
achievements. In its purest sense, we would choose
which good points to copy, and which bad points to
discard. In this way, we would hope to be even better
than the standard or benchmark we have chosen.
The investment world operates along similar lines,
although the use of benchmarks is quite varied.
What are benchmarks used for?
Benchmarks are generally used to measure fund
performance, manage risk, build fund portfolios and/or
set objectives for a fund's returns.
The performance of a portfolio is compared against its
benchmark and the difference calculated. Analysis is
then done to find out where the portfolio manager
added to or detracted from performance. This gives
insight into how the portfolio was structured, and the
various positions that the portfolio manager has taken.
To illustrate, the table below compares the median
equity returns of the largest asset managers in South
Africa (as provided by Riscura) to the returns on the All
Share Index since 1998 and calculates the relative
Performance measurement (in the form of attribution
analysis) would then analyse this out-or underperformance.
Typical areas of focus would be: which
shares have added to or detracted from
performance?; or which sectors have had the best
returns and has there been sufficient exposure to
Tracking error indicates how likely it is that the
portfolio's performance may be different to that of the
benchmark. Some portfolios are managed within a
maximum tracking error limit, thus setting out in
advance how big these differences can be. However,
this does not necessarily control the absolute risk of
the portfolio - just the risk relative to its benchmark. If
the inappropriate benchmark has been chosen in the
first place, then a tracking error limit cannot control the
overall risk in the portfolio.
Sometimes benchmarks are used to construct an
equity portfolio. When deciding how much of any
share to have in a portfolio, a portfolio manager may
refer to that share's size in the benchmark. The risk
with this type of benchmark usage is that the fund
manager may be tempted to "hug" the benchmark very
closely, instead of investing in those shares that offer
the best value.
Benchmarks are often used to calculate a desired
return objective, for example a fund could aim to
achieve performance of the All Share Index plus 2%.
Inflation is a very important factor in determining a
return objective. Many funds will set an objective in
relation to inflation, for example a targeted return of
inflation plus 5%. Any investment which beats inflation
has provided a "real" return. This is essential in
planning for retirement in order to ensure that savings
maintain their value in an inflationary environment.
|Mediun Equity Return
|Out or Under Performance
| Dec 1999
| Dec 2000
| Dec 2001
| Dec 2003
|Annualised Returns Dec 1998 - Dec 2004
Types of benchmarks
Benchmark choice is pretty wide in South Africa, but
some of the more commonly used benchmarks for
equity investments are:
The All Share Index or ALSI:
This consists of all shares listed on the Johannesburg
Stock Exchange. Each share is weighted according to
its size, with some of the larger shares exceeding 10%
of the index. This can pose some practical challenges
as many investment vehicles are prohibited by law
from holding more than 10% of their portfolios in any
one share. How can portfolio managers aim to
outperform a benchmark when they are restricted from
owning the full contents of that benchmark?
In an attempt to address the size issues of the ALSI,
the CAPI was introduced in July 2003. This index limits
all stocks to a maximum of 10%, thus "capping" them.
This index adjusts for the effect of foreign ownership in
our market. Certain shares are listed both in South
Africa and offshore, known as dual-listed shares. The
proportion of these dual-listed shares held by
foreigners is excluded when calculating the size of
these shares in the index. This down weights more
shares than the CAPI does and thus further reduces
the size issue of the ALSI.
So which benchmark is best?
Sadly, there is no one-size-fits-all benchmark. The
choice of benchmark has to be made in relation to the
investment profile and risk of the underlying fund.
Clear objectives have to be set and used as a
framework for choosing the best benchmark.
Creating a benchmark that is easy to beat is not
necessarily in the investor's best interests. What is in
the investor's best interests is ensuring that the
benchmark will assist in delivering real risk-adjusted
returns over the longer term. Ultimately benchmarks
should be another tool to ensure that retirement
savings do actually finance our retirement.