Thinking about benchmarks is going through a paradigm shift. Investors are looking up from the microscope of relative returns to consider the broader implications of asset management: Why am I investing? What's my real goal? How do I define risk and how much of it am I willing to assume?
While benchmarks have a place, it's clear that their dominance in the investment management arena is changing.
Forty years ago, the big question that investment managers were asked was "How much did we make?" Investors were, at that point, talking about dollars or percentage points. In the late '70s, the question was, "Did we beat the index?" In the '80s, the proliferation of specialty managers spawned a cornucopia of benchmarks to measure manager performance against more specific mandates such as the Russell 1000 Growth, S&P/BARRA Value, Wilshire 5000, Lehman Intermediate Gov/Corp and ACWI (All Country World Index).
The focus on relative returns sharpened in the '90s with the market making new highs every month. The '90s question was, "By how much are you beating the market and your peers?" Increasing returns were assumed. Finally, the turn-of-the-century market meltdown forced investors to begin to think more carefully about the risk they were assuming in the pursuit of returns.
RFPs began to ask for things like information ratios. We think this kind of focus on risk/return versus specific benchmarks marks the bottom of a very long term trend of micro-analyzing portfolios. Why? Because institutional investors, fed up with rationalizations for losing money, are asking the long forgotten question, "How much did we make?"
Astonishingly, benchmarks have proven that they can go negative or generate returns that are too small to pay for pension liabilities or charitable programs. People want to know one thing. Will we have enough for what we need? That's the paradigm shift.
Retail investors, last to the benchmark party, are leading the march away from it. They've always wanted to know how much they're making -- after tax! Retail providers took the hint. Two recently opened products operate in a "benchmark - agnostic" world. Merrill Lynch's Global Allocation Fund (MALOX), which invests internationally, domestically and in stocks and bonds to generate returns. PIMCO has taken the freedom from benchmarks to new heights by adding a global tactical allocation feature to its All Asset Fund (PASAX). Their sub advisor, Rob Arnott's newly formed Research Affiliates, allocates money among PIMCO funds in pursuit of returns well in excess of the Consumer Price Index.
Institutional investors are coming on board. Trustees are becoming less interested in hearing about relative returns. They want to know about the funded status of their liabilities. "Will we have enough for what we need to do?"
Given the weaker expected returns for equities and bonds, institutional investors have become increasingly willing to listen to alternative ways of making ends meet. The last couple of years have been marked by an extraordinary growth in hedge fund education, investing and discussions of absolute alpha.
That demand has softened consultants' stand on tracking error vs. specific benchmarks. Managers are being sought or authorized to manage across broader mandates in hopes of a higher probability of generating consistently positive returns.
One could argue that the seeds of this movement were planted at the end of the 20th century when fixed income managers were given discretion to invest overseas and in high yield securities to tweak the returns of Aggregate Bond active portfolios. Still measured against the Agg, these new Core Plus managers put some "oomph" in the slowing bond returns.
Large cap managers, today, are being granted the authority to drift into midcaps if that's where they find value. EAFE managers are being allowed to stray into emerging markets at their discretion. Holding cash when attractive stocks cannot be found is no longer the taboo it once was.
At the extreme end of this spectrum, some plan sponsors are choosing to outsource the investment of their entire plans to managers. Sharing fiduciary responsibility with the trustees, these managers have a mandate to meet or exceed the sponsor's targeted return rate. Frank Russell and SEI are the leaders in this marketplace and consulting firms like Mercer and Watson Wyatt are throwing their hats in the ring. While these outsourcing managers may use narrower benchmarks for the subadvisors they hire, their own clients simply want them to show them the money.
For the individual long-only manager, the most important standard to attain continues to be demonstrated expertise in doing what one says one can do: beat the S&P 500, beat a blend of Wilshire 5000 and the Agg or generate an average of 10% over the CPI with less volatility than the Russell 3000. Consistency has and will always be a key determinant of success in this industry. However, it is clear that the investing public is much more broad minded in terms of how success will be measured. Managers should take the opportunity to reconsider what they truly offer the investing public and position themselves accordingly.
