A better breed of benchmark

In the search for better returns investors have tended to focus on finding managers capable of outperforming a benchmark. They would be better off looking for a manager who also has a better benchmark.

During a high-jump competition, spectators might marvel at how easily the athletes clear the bar, but they know that it is the height of that obstacle, not the height of the jump, that really matters. The same should apply to fund management, though it rarely does.

Investors have historically been more impressed by how much a manager beats a benchmark rather than the performance of the benchmark itself. To a large extent this has meant managers have spent time and resources targeting outperformance. It is rare that they have sought ways to raise the bar itself.

This is a pity. Managers who improve their benchmark, through structural change of the component elements, can deliver significant improvements to the risk/return profiles of their funds. This has been the experience of Fortis Investments, which two years ago launched its ‘smart benchmark’ with the aim of improving the risk/return profile of the benchmarks used by its three mixed portfolio funds (stability, balanced and growth).

The benchmark, launched in 2002, capitalised on the accepted theory of the benefits of diversification, but it was innovative in that it was the first benchmark to employ four little-used diversification asset classes: European real estate; euro corporate bonds; European small caps; and European convertibles.

Extensive back-testing of the optimum strategic allocation of these asset classes identified a benchmark that would, in theory, reduce risk while maintaining the current level of returns – effectively arriving at a benchmark that was the equivalent of the best possible passive fund given the assets used. The results of the back-testing suggested that the smart benchmark would deliver a risk reduction of about 15 per cent, against the old benchmark, while maintaining returns at the same level.

Since launch the smart benchmark’s performance has been excellent. In the two years from November 2002 till November 2004 the benchmark – for the balanced strategy fund – recorded volatility of 7.46 per cent; the volatility of the old benchmark over the same period was 8.86 per cent. This reduction in volatility, of 15.8 per cent, was in line with our expectations.

Unexpected bonus

The smart benchmark has, however, delivered more than just the expected risk benefits; it has also provided a return bonus. The return from the new balanced-fund benchmark, for example, was 13.93 per cent over the two-year period; some 3.84 per cent higher than the return recorded by the old benchmark over the same period. This result, as welcome as it is, was not predicted in pre-testing. And yet there is good reason to believe that it is no fluke. The improvement in return was spread over the two-year period, suggesting that it is not the result of isolated, or one-off, investment conditions.

Excess return, smart balanced benchmark vs old benchmark Just as encouraging is the fact that almost all the new asset classes contributed to the increase in performance. The allocation to real estate added 1.4 per cent to performance and small caps contributed 1.15 per cent, while euro corporate bonds added 1.03 per cent. The contribution from convertibles was marginally negative, largely due to a fall in volatility in the equity market. The remainder of the outperformance was the result of a change to currency exposure; the new benchmark has a slightly higher exposure to sterling at the expense of the US dollar, which has fallen over the past two years.

The combination of the expected improvement in risk and the largely unexpected improvement in returns created a significant overall improvement in the risk/return profile of the benchmark, as measured by the Sharpe ratio. The balanced fund’s benchmark ratio of 0.49 per cent is almost two times better than the old benchmark’s measure of 0.25 per cent.

The return bonus afforded by the smart benchmark is all the more important in today’s low-return environment where low absolute yield levels have combined with declining earnings growth to threaten the performance potential of the traditional core asset classes of govern-ment bonds and equities.

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