Home Finance Criteria for Benchmark Validity

Criteria for Benchmark Validity

by Gerua William

Active investment management is at the center of many criticisms from investors that believe risk-adjusted performance is worse for actively managed funds than index funds. However, incorrect benchmarks proxies have been used to compare performance. Here are the criteria to know whether the benchmark is valid or not.

Measurable

You can quantify a measurable benchmark using numbers over a specific time horizon. Bear in mind that there are benchmarks whose underlying securities (that make up the index) are infrequently traded. During such instances, the benchmark proxy cannot be accurately measured.

As a consequence, comparing the performance of an actively managed strategy relating to this type of benchmark wouldn’t be valid.

Investable

When a benchmark is investable, it means it is possible to forgo the use of active investment management and depend on an index fund to replicate performance.

Absolute performance indexes, factor-model-based benchmarks, manager universe benchmark fail to meet this standard since there is not a comparable investment vehicle with these types of strategies.

Thus, comparing the performance of an actively managed strategy to these types of benchmark wouldn’t be valid.

Appropriate

This criterion tries to ensure that the benchmark properly measures the performance of the investment strategy.  Broad market indexes usually do not meet this standard since most investment strategies have a customized focus.

Thus, comparing the performance of an actively managed strategy to a broad market index would be valid, except when the investment manager uses an actively managed broad market investment strategy that can be compared to the index.

Unambiguous

For a benchmark to be unambiguous, it must be one with known underlying components with clear weightings.

Style indexes usually do not meet this standard since performance is usually dependent on the definition of the style used by the index provider.

Therefore, comparing the performance of an actively managed strategy to a style index wouldn’t be valid, except when both the index provider and investment manager define the style in the same way.

Up-to-date with Current Investment Opinion

The benchmark should be reflective of current investment opinion in a manner that the investment manager has current investment knowledge of the securities or factor exposures that make up the benchmark.

Factor-based model benchmarks usually fail to meet this standard since investment managers do not think in terms of factor exposures when they are creating their investment strategies.  Therefore, comparing the performance of an actively managed strategy to factor-based model wouldn’t be valid.

Specified Ahead of Time

Being specific means that the makeup of the benchmark is disclosed before the start of the evaluation period.  Median manager benchmark proxies fail to comply with this criterion since the median manager can only be established ex-post and also because the median manager will differ from one time period to the next.

Additionally, returns-based indices fail to comply with this criterion since the regression relation used to determine the beta coefficients for each asset class that composes the benchmark is not constant. That means it cannot be specified in advance.

Thus, comparing the performance of an actively managed strategy to a median manager index or returns-based index wouldn’t be valid.

Leave a Comment