Performance Perspectives Blog

Should we blend?

by | Aug 19, 2011

A client alerted me about a new Q&A that is on the GIPS(R) (Global Investment Performance Standards) website. I’ll save you the trouble of looking it up, and provide the particulars here. First, the question: 

“For one of our composites, we use a portfolio-weighted custom benchmark that is created monthly using the benchmarks of the individual portfolios in the composite. The GIPS standards require that if a firm changes the benchmark, the firm must disclose the date of, description of, and reason for the change. Given the nature of the benchmark, the benchmark is subject to change each month. What must be disclosed to satisfy this requirement?”

The response is interesting: “The GIPS standards require that if a custom benchmark or combination of multiple benchmarks is used, the firm must disclose the benchmark components, weights, and rebalancing process. In this example, the benchmark may change every month as part of the normal procedure. It is required in this instance to disclose that the benchmark is rebalanced monthly using the weighted average returns of the benchmarks of all of the portfolios included in the composite. A firm is not required to disclose how the underlying portfolio benchmarks and weights have changed each month. If the benchmark for the composite were to change from a portfolio-weighted custom benchmark created monthly using the benchmarks of the individual portfolios in the composite to a market index, this would be a benchmark change that must be disclosed

“In the spirit of full disclosure and fair representation, firms must disclose the components that comprise the portfolio-weighted custom benchmark, including the weights that each component represents, as of the most recent annual period end. Firms should also offer to provide this information for prior periods upon request.

“Sample disclosure: The Long US Government/Credit Custom Benchmark is calculated using the benchmarks of portfolios in the Composite. The benchmark is rebalanced monthly based on the beginning values of portfolios included in the composite. As of December 31, 2009, the breakdown of the benchmark is 88.2% Barclays Capital US Long Government/Credit Index and 11.8% Barclays Capital US Long Government/Credit A+ Index. The breakdown of the custom benchmark for different time periods is available upon request.”

Our client, and we as well, found this approach to benchmarking quite unusual. Usually when we think of a custom benchmark it is constructed to align with a strategy for which a single benchmark doesn’t work (e.g., a balanced approach, whereby we’d find an equity and fixed income component). Here, the manager has a composite where the underlying portfolios all align with different benchmarks. I would respond to the question with a series of questions.

Does the manager actually manage differently for each of the client benchmarks, or does the manager manage against a common benchmark? If it’s a common benchmark, then it should be the one that’s used. If the manager manages differently for each client, in accordance with their respective benchmark, then why aren’t they using different composites, since benchmark is an acceptable criteria for composite construction?

If the manager feels that the differences between the portfolios is not material, then I would advise them to pick one of the benchmarks and use that. What value is a benchmark that reflects a dynamic mix of underlying benchmarks, each representing the strategy for of a different client? And asset-weighting them means that the larger account’s benchmark rules, yes? But why? And don’t forget, the firm can provide additional benchmarks for reference purposes, too!

I think this question calls into the issue of the role of the composite benchmark: is it not to provide a basis to compare the manager’s successful implementation of their strategy? If the manager is managing across multiple benchmarks, they may have success with one and failure with another: combining them means what, then?

This is an interesting topic, I think, and one worthy of some reflection, too. Your thoughts are welcome.