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Aug 27

Jonathan Pain slams fund manager benchmarking

Apparently Mr Pain is of the belief that equity managers should have benchmarks that are more aligned with their client’s needs and therefore, as far as I can tell, have more of a cash plus or absolute return benchmark. Perhaps I’ve misinterpreted the report but anyway…

…whilst on face value this sounds quite reasonable as it may be difficult to argue with aligning an investor’s needs with the fund manager goals, unfortunately it is not realistic.

Current standard benchmarks of equity managers are typically market cap weighted benchmarks such as the S&P/ASX200 or S&P500 indices and because of their market cap weighting they are effectively a reasonably accurate representation of the “Market Portfolio”. William Sharpe showed many years ago that the “Market Portfolio” represents the maximum achievable diversified portfolio (with a few assumptions I won’t bore you with) and by definition contains no idiosyncratic (or non-market risk) and contains only market risk….and…this is why the market-cap index is used as the benchmark for a fund manager. When you invest in equities you are accepting market risk and if you are an active manager you are also accepting non-market risks (or risks specific to your active bets) that may win or lose or go up or down.For an active fund manager to display skill they must show that, over a specific period of time, their active equity bets must produce a risk-adjusted return that is greater than the market’s. Markets go up and markets go down and to compare an equity market return to an absolute return benchmark is ‘relatively’ meaningless.

Now I do agree with the need to align the benchmark with a client’s needs and I believe this what the strategic asset allocation is for. The asset allocation must be designed with the aim of achieving a return goal over a specified time period and of course at the minimum possible risk. Aos a result the portfolio is designed with the client’s needs in mind and over time, as the portfolio moves, the needs must be revisited and the portfolio’s asset allocation adjusted to meet those needs (or return needs)…unfortunately the commonly used risk profile approach has little consideration of these issues and fails to adjust a portfolio appropriately after significant market movement (e.g. why accept additional risk if you don’t need it and the goal is almost reached).

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