Benchmark Mis specification

Benchmark Mis specification

Performance evaluation and attribution require selecting an appropriate benchmark. When benchmarks are mis specified (that is chosen incorrectly), performance measurement will be incorrect; both the attribution and the appraisal analyses will be useless. For example:

A US equity manager is being evaluated. The sponsor uses the MSCI North American Index to evaluate the manager. US stocks constitute a majority of the MSCI North American, but the index also includes two other developed markets (Canada, and Mexico). Thus, the MSCI US Index more closely represents the manager's normal portfolio. The 2018 returns are as follows:

Manager return: 17.5%

MSCI North American (investor's benchmark) return: 18.0%

MSCI US (normal portfolio) return: 17.0%

Although the manager underperformed the investor's benchmark (17.5% for the manager versus 18.0% for the Mis specified Benchmark), the manager outperformed when correctly benchmarked against the normal portfolio (17.5% for the manager versus 17.0% for the normal portfolio).

Peer Groups as Benchmarks

Peer group benchmarking uses the peer group median as it's target return. This can often lead to an incentive not to underperform the median return, rather than to seek higher returns. This can cause misalignment of incentives between portfolio managers and their clients. It also leads to clustering of returns around the median.

Underperforming managers have been known to change benchmarks to improve their measured excess return, which is both inappropriate and unethical.

Using a broad Index as a Benchmark

Many investors use a broad market benchmark for manager evaluation. The manager's active return is measured as:

$$ \text{Active return} = \text{manager’s return} – \text{broad market benchmark return. } $$

There is most often a mismatch between the broad market benchmark and the manager's “normal” portfolio or benchmark; this is not the manager's “true” active return but is more appropriately termed the “misfit active return”. Using a broad market index typically misses the manager's style (i.e., creates style bias).

Question

Consider a manager who invests in Canadian growth stocks. The sponsor uses the broad Canadian 3000 equity index (the “investor's benchmark”) to evaluate the manager. However, the manager's normal portfolio is better represented by his or her universe of growth stocks. In this example, the manager returns 15%, the Canadian 3000 (the investor's benchmark) return is 10%, and the manager's normal portfolio return is 18%. The manager's misfit active return is:

  1. 5%.
  2. -3%.
  3. -5%.

Solution

The correct answer is A.

The manager has outperformed the investor's benchmark (15% versus 10%), which is also known as the misfit active return. The manager has underperformed when correctly benchmarked against the normal portfolio (15% versus 18%).

B and C are incorrect. The manager's misfit active return is 5%. 

Performance Measurement: Learning Module 1: Portfolio Performance Evaluation; Los 1(m) Describe the impact of benchmark misspecification on attribution and appraisal analysis

Shop CFA® Exam Prep

Offered by AnalystPrep

Featured Shop FRM® Exam Prep Learn with Us

    Subscribe to our newsletter and keep up with the latest and greatest tips for success
    Shop Actuarial Exams Prep Shop Graduate Admission Exam Prep


    Daniel Glyn
    Daniel Glyn
    2021-03-24
    I have finished my FRM1 thanks to AnalystPrep. And now using AnalystPrep for my FRM2 preparation. Professor Forjan is brilliant. He gives such good explanations and analogies. And more than anything makes learning fun. A big thank you to Analystprep and Professor Forjan. 5 stars all the way!
    michael walshe
    michael walshe
    2021-03-18
    Professor James' videos are excellent for understanding the underlying theories behind financial engineering / financial analysis. The AnalystPrep videos were better than any of the others that I searched through on YouTube for providing a clear explanation of some concepts, such as Portfolio theory, CAPM, and Arbitrage Pricing theory. Watching these cleared up many of the unclarities I had in my head. Highly recommended.
    Nyka Smith
    Nyka Smith
    2021-02-18
    Every concept is very well explained by Nilay Arun. kudos to you man!
    Badr Moubile
    Badr Moubile
    2021-02-13
    Very helpfull!
    Agustin Olcese
    Agustin Olcese
    2021-01-27
    Excellent explantions, very clear!
    Jaak Jay
    Jaak Jay
    2021-01-14
    Awesome content, kudos to Prof.James Frojan
    sindhushree reddy
    sindhushree reddy
    2021-01-07
    Crisp and short ppt of Frm chapters and great explanation with examples.