How important are benchmarks for investors?

Written by: Paloma Kubiak
There are more indices than funds available in the investment universe, but what role can they, and should they play in portfolio construction?

A benchmark is a yardstick by which investment funds measure their performance. Fund managers typically try to outperform a certain benchmark. For example, a UK fund manager may benchmark their investment performance against the FTSE All Share index.

As well as measuring performance as they enable investors to compare a fund against other funds and the market, they also allow investors to see whether an active manager is adding value – ie are they worth the fees you’re paying them to generate returns?

In recent years, the effectiveness of active fund managers has been brought into question as investors become more cost aware and more conscious of the efficiency of passives.

But away from the active/passive argument, Adrian Lowcock, investment director at Architas, says benchmarks do have a role to play for investors.

“If they don’t, how does an investor know if they are on course to achieve their objectives?,” he says.

But he does question to what extent benchmarks are really relevant to the investor as active funds “have a tendency to hug the benchmark for fear of failure”.

Lowcock says: “The importance of benchmarks is reducing as few investors want to beat a benchmark that has fallen 30% and the fund only falls 27% – it doesn’t mean much to investors who understandably expect a different result. It also doesn’t help them achieve their goals. With more people investing for retirement, outcomes are more important.”

He says there is a growing focus for ‘outcomes’ rather than beating a benchmark as this is what really matters to investors. Further, benchmarks don’t portray the risks to investors.

“Just because you outperform or under perform a benchmark doesn’t mean much to the risk you are taking. Arguably if you were beating the FTSE 100 over five years, you could be seen as taking less risk because the manager has strong stock picking skills,” he says.

Darius McDermott, managing director of Chelsea Financial Services and FundCalibre, says there have been some funds launched recently without a benchmark, but a handful of funds have also taken away their benchmarks: “Some seemingly to mask poor performance – but they are small in number,” he says.

“What we are seeing more of are funds that have an objective or target. For example X% more than cash or y% returns per annum. I don’t think it is a problem as such if a fund doesn’t have a benchmark as long as investors can understand an objective or target and see whether a fund is meeting these aims or not.”

McDermott says that when it comes to comparing funds, a benchmark can be useful, but most funds, other than those that are ‘unclassified’, will have a sector full of peers that investors can measure them against.

You can also measure return which is often interchangeable with performance.

Lowcock explains: “If you have an outcome target then you can target a return per annum which will give you your own benchmark. But the key issue is the volatility – how much are you willing to take to get your outcome?”

Multi-asset, absolute return funds and passives

Investment research and management firm, Morningstar, says there are more indices than investment funds available but in the multi-asset sector, you can’t find any benchmarks, according to Randal Goldsmith, senior analyst and lead on multi-assets and alternatives.

“If want to have a benchmark for multi-asset funds, you have to create it. This is usually a blend of benchmarks such as those of the equity or fixed income sectors,” he says.

He continued: “Instead of having a composite benchmark or trying to outperform a peer group, they try to achieve a return objective or margin risk for a volatility band or an income target yield. As an example, you may see CPI + 1% or CPI + 3% and a lot of multi-asset funds follow this approach – managed to an outcome.”

Goldsmith says the other area where we just don’t get benchmarks very much is the absolute return area. “By definition, it focuses and is managed to achieve an absolute return,” he says.

He adds that benchmarks are better for more homogenous investments, like those within the EU or North America for instance, where an established benchmark is used so there’s “no need to create something as you do for multi-asset funds”.

“If you take a UK equity fund, any one equity fund is not going to look so different to another UK equity fund. In comparison, one multi-asset fund can look completely different to another,” he says.

Returning to passives or tracker funds, such as Exchange Traded Funds (ETFs), they track a benchmark so here a benchmark is vital and Lowcock says they are being created all the time to allow new passive products.

Goldsmith says it’s important for investors to think about whether it’s worth paying manager fees and ongoing charges.

“A FTSE 100 index tracker won’t be free but the charges will be lower. You can pick it up for single digit basis points.

“If you don’t think a fund manager is adding value, you have the option to buy an index instead at a much lower charge.

“The multi-asset equivalent would be an outcome orientated approach which could target a return risk and return profile,” he says.

What about unconstrained funds?

An unconstrained fund is one that doesn’t have to stick to its benchmark in any way. It may not have to invest in a stock if it doesn’t want to and can choose how much to invest.

However, there are still certain rules which they must follow. For example a UK All Companies fund can’t hold 50% in foreign shares and it can only hold up to 10% in any one stock.

Lowcock says this helps ensure investors are actually getting exposure to what they think they’re buying while McDermott argues that in some cases, it can be difficult to have conviction in them.

He explains: “For example, you will always be underweight Apple in an actively managed tech fund as the manager can only invest up to 10% and Apple’s index weighting is larger than this.”

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