Does Your Benchmark Choice Matter? | Chief Investment Officer

Investors’ choice of benchmark is “not statistically significant,” according to a long-term study of index performance.

“We conclude that the strongest driving force of considered benchmark portfolios is the market factor.”Having tracked the performance of S&P 500 stocks over a 23-year period from 1989 to 2011, Yuliya Plyakha of the University of Luxembourg claimed that “researchers should not worry too much about the choice of the benchmark portfolio for testing asset pricing models in case of sufficiently long sample period.”

“Value-weighted and equal-weighted portfolios of 500 stocks can be used interchangeably,” Plyakha stated in her paper, “Benchmarking Benchmarks: Much Ado About Nothing.”

Plyakha—who now works in MSCI’s portfolio analytics team—studied the performance of S&P 500 constituents according to a number of “traditional and new” benchmark rules, including equally weighted, minimum variance, Sharpe-ratio constrained, and dividend-based models.

Want the latest institutional investment industry news and insights? Sign up for CIO newsletters. 

“We conclude that the strongest driving force of considered benchmark portfolios is the market factor,” Plyakha wrote. More than two-thirds of the dynamics observed in the 23-year period covered were down to the “market systematic factor”—or market beta—the paper said.

“This result implies for big mutual, pension, and hedge funds with long investment time horizons that the choice of their benchmark is not important, and that sticking to traditional value-weighted benchmark is good enough,” Plyakha said. “If the fund is small, around 100 assets, equal-weighted benchmark would be a better choice.”

Plyakha added that her findings demonstrated that “irrespective of the benchmark portfolio, fund managers mainly track the market and do it in a statistically sufficient way.”

Despite hedge funds’ disappointing performance since the financial crisis, investors should keep them in their portfolios—but only if they can invest better.

According to Aon Hewitt, some of the temporary and cyclical drags on hedge funds, such as artificially dampened volatility, are expected to lift.

Asset classes that have been highly correlated since 2008, largely due to central banks’ monetary policies, are likely to move more independently, the consulting firm said.

“This makes us more optimistic that hedge fund returns may not prove quite the disappointment they have been over the last few years,” the report said.

Want the latest institutional investment industry news and insights? Sign up for CIO newsletters. 

Furthermore, Aon Hewitt argued hedge fund returns will look especially attractive as traditional asset classes move into a mediocre- to low-return environment with an expected rise in volatility.

These conditions are likely to push hedge funds to provide steadier returns in challenging markets and “cushion portfolios against a rising risk that equities and bonds will disappoint,” the consultant firm said.

According to the company, even with the asset class’ poor returns over the last seven years, portfolios with hedge funds generally did better in terms of risk-return than any combination of equities and bonds over the last decade.

But simply including hedge funds in the portfolio is not enough. Investors need to do better, Aon Hewitt said, as the average hedge funds “will not deliver the portfolio enhancement that we are looking for.”

Due to a wide range of returns even for funds seeming to use the same strategy, investors need to be able to pick the most skilled managers and the right funds to make hedge funds “worth it,” the firm said.

In the expected low-return environment, Aon Hewitt recommended macro strategies, particularly discretionary and systematic strategies that are not driven by wider market movements.

Aon HF Source: DataStream and Aon, data as of June 2015