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%. 

Reading 12: Portfolio Performance Evaluation

Los 12 (m) Describe the impact of benchmark misspecification on attribution and appraisal analysis