ACTIONABLE ADVICE FOR FINANCIAL ADVISORS: Newsletters and Commentaries Focused on Investment Strategy

Why should clients seek out investable benchmarks?

June 4, 2014

by Jason M. Laurie

of Altair Advisers

Benchmarks are fundamental measuring tools that gauge the relative performance of securities, investment managers and portfolios. They help answer the question, “How are my investments performing?” Yet despite their importance, they often have inherent shortcomings that can make them less than optimal for evaluating performance. 

One of the most significant flaws is that indexes, not index funds, are widely used as benchmarks to compare performance. That may seem like a distinction without a difference, but it is not. Indexes are theoretical; they represent a group of securities without any costs and free from all the practicalities of implementing a portfolio, whereas, index funds are the real thing. Not surprisingly, the performance of an actual index fund may differ considerably from that of the index benchmark it is attempting to replicate. 

So why aren’t investable benchmarks the norm? Blame habit and practicality. It has long been good enough to select an index based only on whether it best represents the active manager’s investment style and not on the practical implications of investing in the index. Also, it can be difficult to identify funds that accurately replicate many of the widely used indexes. Thus even the term “investable benchmark” is not widely used in the investment world. 

But that world is changing. 

The CFA Institute, a global association of investment professionals, notes in its guidelines that a tenet of investing fundamentals is to have benchmarks that, among many other characteristics, are investable—a crucially important property but perhaps the hardest to achieve. In other words, it should be possible to forgo an active manager and simply invest in the benchmark. 

And that can be done. 

In the past only a limited number of widely used indexes were easily investable, most notably the Standard & Poor’s 500 Index as a proxy for large-cap U.S. stocks. However, given the explosion in the 2000s of exchange traded funds (ETFs) and other passive vehicles that attempt to replicate major indexes, it is now possible to switch to investable benchmarks for an entire portfolio.

The selection is not easy. Choosing investable benchmarks requires an advisor to review all available funds and ETFs to find those that best mimic active strategies, but on a passive basis. Benchmarks should be selected based on their historical performance, standard deviation, portfolio characteristics, fund size, liquidity and fees in order to find new benchmarks that most closely resemble their investment targets.

Indexes are harder to replicate in certain asset classes, such as emerging markets, where the impact of currencies and transaction costs involved with purchasing international stocks is not reflected in the performance of an index. Similarly, the common indexes used for municipal bonds are difficult to replicate, as many of the securities included in these indexes are not traded, so the sample size of any fund will inevitably be smaller. Despite these complications, it is far more meaningful and representative for investors to compare their performance in these categories against a real investment option than against the fantasy, non-investable index benchmarks.

Ultimately, we believe investable benchmarks are a best practice that will become commonplace. They enable clients to see what their returns would have been had they invested in a passive alternative to any actively managed recommendations. By giving clients a clearer picture of their portfolios’ relative performance and a more realistic view of an all-index fund alternative, we help put them into a stronger position to make decisions about their money.

In an industry often clouded with obscurity, investable benchmarks are a refreshing source of clarity.

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