Instead of asking ‘what is a long-term model for investment benchmarks,’ we can ask ‘how many institutions view long-term benchmarking as practical?’
Few issues bedevil long-term institutions more than how to benchmark their investments. I have learned it firsthand and repeatedly from managing working groups of long-term asset owners and asset managers to establish longer-term provisions for investment mandates.
Why is that? If we can understand why this is so difficult for investors, we can begin to think about what it will take to change things.
Stuart Dunbar, a partner at Baillie Gifford, lends clarity to this challenge in his recent appearance on the Going Long podcast hosted by FCLTGlobal, a non-profit organisation whose mission is to focus more global capital on the long term.
“There is a pretty small amount of money that’s actually being invested in how we would describe ‘what investing should be’,” Dunbar shared with FCLTGlobal’s chief executive officer Sarah Williamson, “and that is, essentially, completely without regard for a benchmark.”
In other words, there is no such thing as a long-term benchmark.
Dunbar’s view makes it evident why long-term institutions struggle to benchmark their investments – namely, because views span the range from using S&P’s Long-term Value Creation Global Index to nothing at all. Understanding this range of perspective helps narrow the question.
Instead of asking “what is a long-term model for investment benchmarks?”, we can ask “how many institutions view long-term benchmarking as practical?”.
If the answer is “few”, then asset owners and managers will have to make these decisions circumstantially. But if the answer is “many”, we can hold out hope of distilling model practices for selecting benchmarks.
Importantly, nothing from this lesson requires all institutions to find long-term benchmarking practical. It merely requires those that do to appreciate that others around them, including perhaps some of their clients or managers, may disagree. Institutions need to be diligent about this possibility and remediate it the same as they would remediate any other misalignment.
That may be easier than it sounds; investors already have clues about how prevalent these views are in the marketplace.
Asset managers with an active style and high concentration may be more likely to feel that long-term benchmarks are impractical. Benchmarks anchor investors to a top-down perspective on their performance, and these managers’ business model is centred on building portfolios from the bottom up. A client that hears this sort of manager-emphasising benchmarking may suspect that the manager is less active or concentrated than advertised.
Meanwhile, asset managers with an index style and diffuse holdings may be more likely to feel that long-term benchmarks are essential. This tool is fit-for-purpose for them: a top-down tool for top-down portfolio construction. A client that hears this sort of manager suggest that long-term benchmarking is impractical may suspect that they are just masking consistent underperformance.
Note that these are just selected examples. For instance, similar dynamics can be at play for managers based on the depth and liquidity of the markets in which they invest.
Asset owners’ situation is somewhat more complex. They will use both active and index strategies, and they will be accountable to sponsors who depend on cashflows or valuation in order to achieve some purpose in the real world, such as paying a pension benefit, matching insurance liabilities, developing an economy, or funding scholarships.
Those goals are a form of benchmarking, in effect, so it is necessarily the case that long-term asset owners are benchmarked at the total-fund level and also, at least partially, at the level of individual portfolios.
There’s the rub, and the real insight of Dunbar’s comments: just because asset owners set benchmarks at the total-fund fund level, and sometimes at the portfolio level, does not mean that they have to benchmark each portfolio.
Asset owners do have to construct portfolios deliberately to target an expected return over time within clear and deliberate diversification parameters, but that is not the same thing as saying that every single portfolio in the fund must have a benchmark.
Long-term owners therefore need to answer two questions:
“Does having a benchmark enhance long-term focus for this portfolio?” And then, only if so, “What would that long-term benchmark be?”
Benchmarking is likely to remain a complex issue for long-term institutions because there is no correct answer. There is correct process, though, and investors will find it familiar: know your counterparts in a potential agreement, select them for how well they fit into your larger strategy, and remain engaged rather than trusting that numbers tell the whole story.
Matthew Leatherman is a research strategist at FCLTGlobal