The changing role of benchmarks

Benchmark-aware and index investing will likely always have a role to play in the investment world, but as markets have evolved and diversification has become progressively more important, investors are increasingly looking for approaches that are benchmark unaware.

The background to benchmarks

A benchmark is any definable market cross-section. Most are weighted by market capitalisation, but they can also be equal-weighted or fundamentally-weighted, among other measures.

Australia's first share price index was established in 1938. But it wasn’t until December 31, 1979 the All Ordinaries was created as Australia's first national index. It soon became the default instrument against which fund performance or individual stock performance was measured, however this was never its intent.

To address this, almost 20 years ago, the S&P/ASX 200 equity benchmark index was created, which focussed on addressing the investability of the index
reflecting both the size and liquidity of the top 200 stocks in the Australian market.
Equity benchmarks help explain the risks and returns that stem from equity investments. They also help investors understand fundamental factors such as profitability when trying to figure out average corporate performance. They provide context for investors to help judge fund manager success and compare their performance. Given they are published and highly rules-based, they can be easily tracked.

Challenges with benchmarks

Of course, benchmark-aware investing is only one approach. This is important, as large parts of a benchmark may be inappropriate to meet an investor’s requirements. Income is one example.

In the run up to the global financial crisis of 2007/2008, the banking sector produced more than a third of the total dividend income for the UK’s FTSE 100 index. An income investor following a benchmark strategy would have lost 35 per cent of their income as the share market fell following the financial crisis. As a result, this strategy would have been inappropriate for an investor seeking income security.

Additionally, smaller, evolving sectors tend to have a lower weighting in benchmark indices versus mature industries such as banking, energy and mining. Compared to smaller businesses, companies in these sectors may be relatively more cyclical, competitive and capital-hungry, and the ability to generate value (and therefore future market returns) may be more limited.

Benchmark unawareness

As a result, some investors are seeking alternatives to benchmarks. Becoming benchmark unaware does require a shift in mindset and in the focus of an investment team. In contrast to benchmark investing, fund managers are tasked with finding stocks they believe will deliver the outcome clients are seeking.

In this approach, analysis is focussed almost entirely upon the stocks that are likely to meet the client’s needs, since the need to “cover” a stock because it is in a benchmark is removed. This typically increases the depth of research and insights on stocks that are potential investments for the fund.

Importantly, becoming benchmark unaware is liberating. It offers a freedom to find great ideas for clients with a flexible approach. Often teams work within a more generalist model, rather than as sector specialists, which can lead to more collaboration on investment decisions, aiding objective decision making.

Tracking performance

Being benchmark unaware is, however, no excuse for failing to outperform an index over time. But ignoring the benchmark in the near-term in some circumstances may to lead to stronger performance longer term versus the benchmark.

The key is to be clear about the investment process and what’s needed to drive an asset’s long-term performance. For an income fund, that may be cash flow and dividend cover. For a fund seeking capital growth, earnings and cash flow growth may be the salient factors to measure.

Teams can track these underlying drivers for clients and demonstrate they are moving in line with the client proposition. This will help provide comfort that the outcome they are seeking – income or capital growth, for instance – should be delivered over time.

Ultimately what matters to clients is absolute outcomes after all costs. Research suggests that this is often more often achieved via less benchmark awareness – it seems clear that our industry is increasingly heading this way.

Please call us on |PHONE| if you would like to discuss.

Author: David Allen – Meng (Chemical Engineering) Global Chief Investment Officer, Equities London, United Kingdom

Source: AMP Capital 29 March 2019

Important notes: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) (AMP Capital) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided and must not be provided to any other person or entity without the express written consent of AMP Capital.