How to Kill a Black Swan Remy Briand and David Owyong ...

Investment performance cannot be measured without a
benchmark. A good benchmark should be unambiguous,
investable, measurable, appropriate, reflective of current
investment opinions and specified in advance. 1 Certain
indexes serve as good benchmarks because they are tools
designed to measure the performance of a particular market
over time without any unnecessary or unreasonable biases.
This article examines benchmarking issues in both single and
multi-asset class portfolios.
One Small Step …
Within a policy portfolio, single asset class benchmarking
is accomplished using widely accepted methods and procedures.
A benchmark, though, is not relevant on its own; it
must coexist with an investment in an asset class. In practice,
such an investment will typically be assigned to one or more
asset managers who will, in turn, each be given a mandatespecific
benchmark to gauge their performance. The mandates
themselves are often narrower than the asset class,
such as large-cap growth or small-cap value in the equity
space. Any mandate narrower than the asset class should
identify the appropriate subasset class benchmark along with
corresponding weight, specified in advance. 2 Otherwise, the
risk of benchmark misfit is significant.
Benchmark misfit is an investment decision that leads to
uncompensated risk. Prudent investors do not take uncompensated
risks because they do not receive additional return
for doing so. Therefore, benchmark misfit needs to be properly
measured and monitored.
Benchmark misfit is calculated as the difference between
the return of the asset class benchmark and the weighted average
return of all benchmark mandates assigned to individual
asset managers. In other words, misfit exists when the sum of
Figure 1
the assigned parts does not equal the desired whole.
Benchmark misfit can be decomposed into two categories:
(1) gaps and overlaps; and (2) allocation misfit.
Misfit #1: Gaps And Overlaps
Gaps and overlaps occur when the subasset class benchmarks
are mixed and matched among different index providers.
For example, many in the investment community use the
S&P 500 Index and the Russell 2000 Index as the standard
benchmarks for large-cap and small-cap domestic equities,
respectively. Figure 1 illustrates an example of the gaps in market
coverage when the large-cap and small-cap benchmarks
are set to the S&P 500 Index and Russell 2000 Index. The asset
class benchmark has been set to the Dow Jones U.S. Total
Stock Market Index, which covers the entire opportunity set of
all U.S. equity securities with readily available prices.
As of Jan. 1, 2009, the gap in market coverage of the S&P
500–Russell 2000 combination results in 2,165 missing constituents,
which is nearly half of all available constituents.
This equity gap leaves over $1 trillion, or 11 percent, of
the U.S. stock market unaccounted for. The median market
capitalization of the missing 2,165 stocks is $28 million, and
the median market capitalization of the top quartile of those
stocks is $1.51 billion, and includes such names as Genentech
($38.44 billion), Visa ($22.53 billion) and Accenture ($18.03
billion). No reasonable investor should use a benchmark that
excludes the top 11 percent of the U.S. equity market, the
bottom 11 percent or any other 11 percent.
Misfit #2: Allocation Misfit
Allocation misfit exists when asset allocations deviate from
the actual market coverage of the asset class benchmark. Figure
2 illustrates an example of allocation misfit. A hypothetical
Gaps In Market Coverage
Benchmark Constituents Market Cap ($ Billion) Market Coverage
Dow Jones U.S. Total Stock Market Index 4,599 9,662.04 100.00%
S&P 500 Index 500 7,851.81 81.26%
Russell 2000 Index 1,934 745.35 7.71%
S&P 500 + Russell 2000 Subtotal 2,434 8,597.16 88.98%
Gap in Market Coverage 2,165 1,064.88 11.02%
Source: Dow Jones Indexes, iShares fund fact sheets
Figure 2
Allocation Misfit
Benchmark
Subasset Class
Allocation
Actual Benchmark
Coverage
Quarter Ending
March 31, 2009
Dow Jones U.S. Large-Cap Total Stock Market Index 85.00% 88.25% -10.32%
Dow Jones U.S. Small-Cap Total Stock Market Index 15.00% 10.68% -12.42%
Dow Jones U.S. Micro-Cap Total Stock Market Index 0.00% 1.06% -10.06%
Weighted Average Benchmark Performance -10.56% -10.63%
Benchmark Misfit Impact -0.07%
Source: Dow Jones Indexes
www.journalofindexes.com July/August 2009
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