Investment Management
Choosing a benchmark is a pivotal step for an investment manager, following the decision of passive versus active investment or the form of investment. This choice is part of the broader asset allocation process, which starts with a clear definition of the portfolio manager’s investment goals and objectives. These objectives could vary from protecting funds, replicating the broad market, achieving predictable returns within acceptable risk parameters, to maximizing absolute returns through opportunistic means, akin to a venture capitalist seeking high returns from startups.
Investment Policy and Asset Allocation
An investment policy must be agreed upon with the asset owners, beneficiaries, and other constituents. This policy outlines return objectives, risk tolerance, and constraints to narrow down the choices available in the broader capital markets to meet these objectives. A strategic asset allocation targeting specific weightings for each permissible asset class is the result of this process. A tactical asset allocation range often provides the investment manager some short-term flexibility to deviate from these weightings in response to anticipated market changes, similar to a hedge fund manager adjusting portfolio weights based on market forecasts.
Fixed-Income Benchmark Selection
Bonds are a significant part of most asset allocations as they represent the largest fraction of global capital markets, capture a wide range of issuers, and, as borrowed funds, represent claims that should involve lower risk than common equity. However, choosing a fixed-income benchmark is unique as the investor usually has some degree of fixed-income exposure embedded within its asset/liability portfolio. The investment manager must therefore consider these implicit or explicit duration preferences when choosing a fixed-income benchmark.
Smart Beta Approach
For investors seeking to combine the potential outperformance of active management with a broad exposure to an index, a smart beta approach might be suitable. Smart beta involves the use of simple, transparent, rules-based strategies as a basis for investment decisions. The starting point for smart beta investors is an analysis of the well-established, static strategies that tend to drive excess portfolio returns. In theory, asset managers who can isolate and pursue such strategies can capture a significant proportion of these excess returns without the significantly higher fees associated with active management.
Practice Questions
Question 1: An investment manager is in the process of selecting a benchmark for a new portfolio. The manager’s investment goals and objectives include protection of funds, broad market replication, and predictable returns within acceptable risk parameters. The manager has agreed upon an investment policy with the asset owners and beneficiaries, which outlines return objectives, risk tolerance, and constraints. The manager is considering a fixed-income benchmark due to the significant part bonds play in most asset allocations. What should the investment manager consider when choosing a fixed-income benchmark?
- The manager should consider the implicit or explicit duration preferences embedded within the asset/liability portfolio.
- The manager should consider the potential outperformance of active management with a broad exposure to an index.
- The manager should consider the use of simple, transparent, rules-based strategies as a basis for investment decisions.
Answer: Choice A is correct.
The investment manager should consider the implicit or explicit duration preferences embedded within the asset/liability portfolio when choosing a fixed-income benchmark. Duration is a measure of the sensitivity of the price of a bond or a bond portfolio to a change in interest rates. It is a key factor in managing the risk and return profile of a fixed-income portfolio. The duration preferences of the asset/liability portfolio reflect the risk tolerance and return objectives of the asset owners and beneficiaries. If the duration of the benchmark is not aligned with these preferences, the performance of the portfolio may not meet the investment goals and objectives. Therefore, understanding the duration preferences is crucial in selecting an appropriate fixed-income benchmark. This consideration is particularly important for portfolios with significant bond allocations, as changes in interest rates can have a substantial impact on the value of these portfolios.
Choice B is incorrect. While the potential outperformance of active management with a broad exposure to an index can be a consideration in the investment strategy, it is not a primary factor in choosing a fixed-income benchmark. The benchmark should reflect the investment goals and objectives, risk tolerance, and constraints outlined in the investment policy, not the potential performance of active management.
Choice C is incorrect. The use of simple, transparent, rules-based strategies can be a part of the investment strategy, but it is not a primary consideration in choosing a fixed-income benchmark. The benchmark should be selected based on its alignment with the investment policy and the characteristics of the asset/liability portfolio, not the simplicity or transparency of the investment strategies.
Question 2: An investment manager is considering the use of an index as a benchmark for a new portfolio. The manager’s investment goals and objectives include maximum absolute returns through opportunistic means. The manager has agreed upon an investment policy with the asset owners and beneficiaries, which outlines return objectives, risk tolerance, and constraints. The manager is considering a fixed-income benchmark due to the significant part bonds play in most asset allocations. What should the investment manager consider when using an index as a benchmark?
- The manager should consider clear, transparent rules for security inclusion and weighting, investability, daily valuation and availability of past returns, and turnover.
- The manager should consider the implicit or explicit duration preferences embedded within the asset/liability portfolio.
- The manager should consider the potential outperformance of active management with a broad exposure to an index.
Answer: Choice A is correct.
When using an index as a benchmark, the investment manager should consider clear, transparent rules for security inclusion and weighting, investability, daily valuation and availability of past returns, and turnover. These factors are crucial in ensuring that the index is representative of the portfolio’s investment strategy and objectives. Clear and transparent rules for security inclusion and weighting ensure that the index accurately reflects the market or sector it is intended to represent. Investability refers to the ease with which an investor can replicate the index by buying the securities it contains. Daily valuation and availability of past returns allow the manager to track the portfolio’s performance against the benchmark on a regular basis. Turnover refers to the frequency with which securities in the index are bought and sold; a high turnover can increase transaction costs and reduce the portfolio’s net returns. Therefore, these factors are essential for the manager to consider when using an index as a benchmark.
Choice B is incorrect. While the manager should consider the implicit or explicit duration preferences embedded within the asset/liability portfolio, this is not directly related to the use of an index as a benchmark. Duration preferences are more relevant to the selection of individual securities or the overall asset allocation of the portfolio.
Choice C is incorrect. The potential outperformance of active management with a broad exposure to an index is a consideration for the manager’s investment strategy, not for the use of an index as a benchmark. While active management can potentially outperform an index, this is not guaranteed and involves higher risk and costs. Therefore, this is not a primary consideration when selecting an index as a benchmark.
Portfolio Management Pathway Volume 1: Learning Module 4: Liability-Driven and Index-Based Strategies.
LOS 4(g): Discuss criteria for selecting a benchmark and justify the selection of a benchmark