Last week, this column discussed about how to identify closet indexers — those that claim to be active funds but essentially hug the benchmark index. The problem with closet indexers is that they charge a high fee for beta exposure. In response to that article, readers posed several interesting questions. One such question was how to choose benchmarks for diversified funds.
We address the issue of choosing an appropriate benchmark for diversified equity funds. We discuss the importance of benchmarks and the constraints a benchmark poses on truly active managers.
It is both fortunate and unfortunate that most equity funds in India follow multi-style investing. It is fortunate because multi-style funds can generate higher alpha (market outperformance). It is unfortunate because performance evaluation of such fund managers becomes difficult.
Alpha is the excess returns that a portfolio (adjusted for beta) generates over the benchmark index. This excess returns is due to the manager’s skill at security selection and/or market timing.
Suppose a large-cap styled active fund generates 40 per cent returns during a certain period. Suppose the S&P CNX Nifty, the appropriate benchmark, generates 25 per cent return during the same period. If the portfolio beta is 1.5, the beta-adjusted return on the fund should be 37.5 per cent (25 per cent times 1.5). The excess return or alpha is, hence, only 2.5 per cent. Investors usually pay high management fee for alpha returns. Take Reliance Equity Fund. This fund has an expense ratio of 1.81 per cent. The fund’s stated benchmark is the S&P CNX Nifty. If this fund does not generate sizable excess returns, an investor can just as well switch to an index fund that has expense ratio of one per cent or lower.
Benchmarks, therefore, enable investors to ascertain whether fund managers justify the high ‘alpha’ fees that they charge. But choosing benchmarks is not easy. For one, using a narrow-style index as a benchmark for a multi-style fund is not suitable. For another, most diversified equity funds do not provide clear investment objectives so as to enable analysts to apply suitable benchmarks.
Truly active managers do not like benchmarks. The reason is that, in order to beat the benchmark, an active manager is forced to select stocks within the benchmark universe. And that acts as a constraint in generating alpha. Small wonder that Peter Bernstein argues that “traditional benchmarking for active portfolio managers is contrary to the client’s best interest.”
Peter Bernstein’s argument will be more practical for institutional investors. Such investors follow liability-driven investments. That is, they match their investment with their liability structure. The benchmark is the required return on the liability structure. Importantly, the benchmark return varies between one institutional investor and the other. This does not pose any problem as institutional portfolios are typically separately-managed accounts.
Mutual funds are collective investment vehicles. Pooling the required returns of various unit-holders into one useful benchmark becomes difficult. So, required return cannot be used as a performance evaluation benchmark for mutual funds. A benchmark index, thus, becomes the preferred alternative.
To ensure that truly active multi-style managers are not constrained by narrow benchmarks, a broad-based benchmark such as the S&P CNX 500 can be considered. This serves two objectives. First, such a broad-based index encompasses all investment styles ranging from large-cap growth to mid-cap. And second, because this index is stuffed with all kinds of stocks, generating alpha returns becomes difficult. This will weed out funds that invest in large caps and mid caps but use S&P CNX Nifty as the benchmark index to show some alpha returns.
There is a tendency among analysts to use peer universe as a benchmark for performance evaluation. If an analyst wants to evaluate a multi-style fund, the peer universe would be all funds following multi-style investing.
There are several problems in using such peer-group evaluation. The most important characteristic of a good benchmark index is that it should be investible. That is, an investor should be able to replicate the benchmark portfolio either by taking exposure to such shares directly or through an index fund.
A peer group of all diversified equity funds, for instance, fails on this count. The benchmark portfolio is only known at the end of each month, not before. How can this benchmark be replicated?
Appropriate benchmarks enable investors gauge if active funds justify alpha fees. It is equally important to ascertain if such managers consistently generate alpha to justify the higher fee structure.
B. Venkatesh
(The author is an investment strategist. He can be reached at enhancek@gmail.com)
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