| Customised benchmarks 101 |
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| 29.10.2006 | |
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Noël Amenc, Director of the Edhec Research and Asset Management Centre, answers this week's 101 on customised benchmarks 1. What is a customised benchmark? Depending on the case, when we speak of a customised benchmark, we refer to two types. The first type of customised benchmark relates to the evaluation of the manager's performance. It corresponds to a "statistical" benchmark calculated ex post and enables the risks taken over a period to be represented well. The determination of a customised benchmark serves as a basis for assessing the out-performance generated by active management. This customised benchmark is often different from the reference index displayed by the fund because the reference index (except in the case of indexed management or management with a very low tracking error) does not correspond to the allocation choices made over the period studied. The second type of customised benchmark corresponds to a representation of the ex ante strategic allocation decisions. For the manager, this involves making long-term allocation choices on the basis of particular criteria which could be either the search for efficiency (the case of an asset management perspective) or respecting liability constraints (the ALM perspective). 2. What are the problems of broad market indexes? Market indexes are neither efficient nor, of course, representative of the liability risks of a particular investor. The principle of a customised benchmark is to try to avoid these shortcomings to the extent that is possible through the current techniques available in both asset management (optimisation) and ALM. 3. Does a customised benchmark provide more stable risk exposure and efficient allocation than a market index? One of the management strategies of a customised benchmark could be to respect a fixed mix of the risks that it represents and as such guarantee the stability of those risks. Market indices are often cap-weighted so their risk exposures are dependent on the evolution in the stock market capitalisation of their components. 4. Why are broader indexes not as good in efficiency than narrower ones? What is meant by efficiency? Efficiency is defined in the Markowitz/Sharpe sense: that for a given level of risk, there is no portfolio that has a higher return than the one that is on the efficient frontier. There isn't necessarily a trade-off decision to be made between efficiency and the stability of the exposure to the risk factor. Respecting constraints on risk factors can be a modest but effective way of obtaining portfolios which may not turn out to be totally efficient with hindsight, but which are often less inefficient than portfolios that are naïvely optimised beforehand (see related story). |
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