Norway’s sovereign wealth fund has proposed a new approach to benchmarks that it claims can boost the benefits of investing with active stockpickers.
In a discussion note published on its website, Norges Bank Investment Management (NBIM)—which manages the €689 billion ($860 billion) Norway Government Pension Fund Global—explored in depth its use of bespoke equally-weighted benchmarks.
“By lowering the concentration of capital in the largest stocks, the more even distribution of weights allows for a better representation of relative views taken by the portfolio manager,” the report said.
As well as equally weighting stocks in the benchmark, NBIM looked at the number of stocks in a given benchmark and the effects of volatility, correlation, and dispersion. The report concluded that, by giving a portfolio manager a bespoke benchmark from which to select stocks and against which to measure performance, investors can get a better impression of a manager’s ability to add alpha.
Using the European banking sector as a case study, NBIM found that by equally weighting stocks and reducing the number of them, a bespoke benchmark can be created that is sufficient to give an accurate marker for a portfolio manager while also being aligned to the investor’s requirements.
“Our simulation framework can be applied for other sectors to arrive at the appropriate levels of diversification and is sufficiently versatile to reflect sector-specific characteristics and portfolio management styles,” the report said.
Benchmarks can double as research lists for the managers and can be focused on factors such as market cap or volatility—i.e. excluding the smallest or largest companies in the list—but when used as a performance barometer the list is equally weighted.
“The practical implication is to build tailored research lists for the active managers according to their specialisations which will form the universe of stocks for the design of the custom benchmark,” NBIM said.
“Given time and resource constraints in terms of coverage, a typical research list constitutes a subset of names in a given sector specialisation and generally excludes the smallest names in the original benchmark.”
As a result the two “key decisions”, NBIM said, were choosing the size of the research list and selecting how the stocks were to be weighted.
“In broad terms, an optimally diversified sector benchmark should incentivise each portfolio manager to utilise their stock-picking skills, and at the same time to be able to enhance the fund’s overall performance in a scalable way,” the fund’s report concluded.
The full report can be read downloaded from NBIM’s website.
Related Content: 2014 Power 100 #2 Yngve Slyngstad & Norway Adds New CIOs in Radical SWF Overhaul