BackFunds should be pegged to appropriate benchmarks
An investment strategy cannot be measured only against the market bellwether
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Using the right index as a benchmark for a fund has assumed significance given the importance of a fund’s performance. Indices are constructed differently, some by design and some by an accident of history. The key issue to remember when choosing an appropriate benchmark is to look under the hood of each index and make sure that the index design mirrors the same philosophy as that of the fund. Portfolio risk and return can be heavily influenced by benchmark selection. Typically, a fund manager will choose securities from a benchmark and then weigh them differently to achieve the desired outperformance. But if the benchmark selection is wrong in the first place, it will lead to wrong choices for the portfolio.
The recently published Standard & Poor’s Index Versus Active (SPIVA) India scorecard 2014 report gives some clear metrics on fund performance in India. As per the report, over a five-year period, 54% of the large-cap active funds have underperformed their benchmark, S&P BSE 100. While these results are in line with trends seen globally, the general misconception in India is that majority of the Indian funds have outperformed their benchmarks. If one examines this notion closely and looks under the cover, some interesting facts emerge. For one, mostly the index chosen is the price-return version (which only measures price-returns and dividends are ignored), while the fund performance is the total return where all dividends are reinvested back into the fund. When a third of any fund returns comes from dividends, this is clearly a case of mismatching the index to the fund. A total return fund performance has to be matched to a total return index.
Going the next step, global fund managers will demand a net total return index where the returns will be net of dividend taxes levied on offshore investors. While comparing the performance of a fund with a benchmark, it is important to match the two as closely as possible. Often, a fund will include not only large-cap stocks but also some mid- or small-cap stocks that can have a significant impact on the performance. In such a scenario it would be appropriate to use an all-cap index that incorporates all three size segments.
An investment strategy cannot be measured only against the market bellwether. It has to be measured against an index designed to measure the specific theme. Hence, funds that are designated by a theme such as infrastructure or a similar quasi-sector play and are then benchmarked against an all-cap index like the S&P BSE 200 are doing disservice to investors. But a true benchmark would be designed to measure the performance of all infrastructure stocks and not of the entire market.
Similarly, a fund designed to include high dividend paying stocks should use a benchmark whose design incorporates high dividend paying stocks and not a market bellwether large-cap index because a fund manager is justifying her choices by measuring the fund’s theme against market performance.
There are also strategies designed to perform against market trend. For example, in times of a downturn, such strategies provide downside protection or even a positive performance. The need is for a benchmark that is designed along similar lines.
In recent years, the issue of appropriate benchmark selection has assumed enormous significance. Large swathes of pension funds and sovereign funds around the world are waking up to the fact that manager selection is keenly influenced by benchmark selection. If an easy-to-beat benchmark is chosen, an under par performance of the manager will pass muster.
As the fund industry has evolved using sophisticated stock selection criteria, the index industry has moved in lockstep offering more differentiated and well-designed indices for different purposes.
A well-designed benchmark is transparent in its design, and measures a clearly defined market segment. Over the years, indices have diversified to such an extent that any active strategy can find a corresponding index removing any requirement to use the same index as a benchmark to differing strategies. The results of a fund strategy are best understood if the investor can see the performance of the fund manager in her choices against clearly defined peers and comparable strategies. Each investor is entitled to know how her money is being invested and that understanding can only come when the fund strategy and index are both transparent and comparable.
As capital markets mature, and more importantly, the investing public becomes more educated on the nuances of benchmarking and indexing, this issue will assume more significance. In mature markets, such as the US, this is already the case and now other parts of the world are waking up to it too.
Alka Banerjee is chief executive officer, Asia Index Pvt. Ltd.
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