Benchmarking enters new era

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The benchmarking industry has changed significantly over the last five years. The major players may be the same and benchmarks still perform the same function - assisting the investor in forming their asset allocation strategy, setting the boundaries for the portfolio and evaluating the performance of the fund manager.

The difference today is that the index provider will now customise products to meet the fund's exact mandate requirements enabling the request of any type of benchmark excluding or including a selection of economic sectors or particular stocks. This is a debate between the index provider, who shares their expertise with the asset owner, and investor who has more flexibility in the creation of the benchmark to meet the objectives of his fund.


Building global real estate benchmarks

More funds are moving their equity portfolios to global benchmarks - and the benchmarks have improved as greater use is made of them. Most large funds use a combination of the standard index calculations and a range of custom calculations as a performance benchmark for selected active fund managers or as the basis for the core indexed fund whether this is managed in-house or externally.

The continued rise of real estate as an investment style means that global real estate benchmarking has come of age and a range of options to suit the diversity of investment mandates for real estate is now available to the investor. The real estate market has a present day value of approximately €500bn, and to support it, both traditional and newer approaches in indexing are now available to the industry.


New benchmarks for traditional and
new asset classes

The ongoing drive for alpha means that funds are increasingly interested in a range of options to diversify and enhance returns. New asset classes have become more popular with pension funds in the last few years and asset classes which have traditionally been viewed as difficult to measure can now be benchmarked.

Investors have created a demand for more liquid investment benchmarks across all the asset classes, including real estate. The development of a fledgling derivatives market for real estate has also driven the need for new, tradable indices, calculated in real time to sit alongside the benchmarks. An innovative solution to this index challenge in the UK is to use investible funds as constituents in the indices, or REITs as the market in these funds grows. These indices are constructed using performance information from funds which the index provider licenses an external fund manager to construct and run. This new concept has proved to be highly successful.

The concept has also worked successfully in the case of both hedge funds and private banking and brings sufficient transparency to meet funds' exacting disclosure requirements.


Drilling down to capture investment opportunity

New detailed sector indices have recently been created as well. The purpose of introducing property sector indices is to provide investors with a mechanism for managing their exposure to separate cohorts of listed real estate equities, as distinguished by the risk-reward profiles of different property sectors of the real estate business, including office buildings, retail centres, industrial facilities, lodgings and resorts, residential buildings and others.

These sectors have been developed in conjunction and consultation with industry bodies EPRA and NAREIT, who respectively represent the European and North American real estate companies and investment institutions. Investor interest in sector indices is strong, and these new indices are expected to be used as the basis of investment products like derivatives and ETFs.

Another area where indexing has become more specialised is in the REITs space. REITs have become accepted as a proxy for investment in physical property and, as the number of REITs have grown and the number of countries permitting REITs continues to expand (UK being the latest), REITs benchmark indices are the newest property benchmarks.


Cap-weighted benchmarks are only one solution

Many of the world's largest funds are beginning to question the very basic structure of the equity indices. They argue that cap-weighted indices exacerbate the short term pricing anomalies in this market and that by weighting stocks not by their market value but by factors such as net income, cash flow, book value, provides a more robust long-term investment approach.


Is the future in multi-asset customised

As investor needs and requirements change, index provision will change alongside them. Increasing interest from institutional investors across alternative asset classes means that market demand for transparency and measurement can only grow. As individual investors, asset owners and their managers specify their requirements, then the major index companies will create benchmarks to meet their needs.

Benchmark providers have the data, the design and the calculation skills already in place, ready to apply to the specific needs of pension funds and retail investors.

Multi asset customised benchmarks will certainly become more likely, as price sources for bonds improve.

Currently, bond indices are proprietary products, calculated by the investment banks. As the price sources improve and better prices become more available, public index providers will challenge these proprietary products, and be able to integrate them with equities and other asset classes to bring truly multi-asset customised products, including real estate, to meet specific mandates.

Mark Makepeace is CEO at the FTSE Group

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