Reaching for the benchmark

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Pension fund managers looking for a European equities index will be spoilt for choice. Index suppliers have been falling over themselves to come up with many and varied benchmarks to use against investment portfolios.

But while most pay lip service to performance measurement, many of the new creations appear to be aimed at the market for derivatives products and for licensing to providers of guaranteed equity products, for example. They may be of vital use to the passive manager but not really relevant to the active manager as benchmarks.

Owning something like the FTSE 100 can make a lot of money, so that is where most of the new indices are pitched... they are not normally ideal for performance measurement," says Anthony Ashton, director at investment consultant Callan, Bacon & Woodrow.

"All of the new indices which are coming out are narrower indices... this is a clear trend," says Dominic Huou, vice president of the global portfolio strategies group at Merrill Lynch. It is obviously helpful for an index that is to be used as the underlying for a futures or option contract to be narrowly based, because this makes it easier to handle and facilitates arbitrage, he says.

Eric Lambert, executive director, research and consultancy at The WM Company agrees that all the focus in new index development has been on derivatives use. "But the group that has been almost totally forgotten about is the investors, the pension funds," he says.

Whether benchmarks for performance measurement will change at all is unclear. Lambert says in this respect it is not the currency that matters, but volatility, income stream and returns. Only if those benchmarks change will the index change, he says.

At least in the UK and other countries outside the euro zone, most institutional investors will not be changing their benchmarks for pan-European equities, says Sandy Rattray, analyst at Goldman Sachs. However, a Merrill Lynch survey a year ago found that more than half of managers in Europe said they would change performance benchmarks when the single currency comes in.

Standard & Poor's, a major complier of market indices, joined the fray in October by launching new European stock market indices. Acknowledging the narrowness of some European indices, Bill Jordan, director of communications at S&P, said the company saw a gap in the market.

"What you have now is two levels, the broad indexes, for example the FT/S&P and the MSCI... they're good for comparison purposes," he says. "At the other extreme you have these 50-stock indexes which are fine for investability. But no one is going to use a 50-stock index for performance measurement. You can't say Europe can be boiled down to 50 stocks - that's absurd," he says. S&P's new indices cover 200 stocks, giving them the broad coverage of a benchmark and the liquidity of a narrow index, says Jordan.

But 200 stocks is still narrow compared with many European benchmarks currently used, and a far cry from measuring performance using a peer group such as CAPS or WM in the UK. The European equity universe consists of about 5,400 listed securities. Lambert says index providers appear torn between on the one hand wanting to provide a very broad market index and on the other hand serving the different requirement of the derivatives market. An index gains substantial credibility if it is commonly used as a performance measurement tool for funds; this may be why the index suppliers are trying to play simultaneously to two very different markets, he says.

Many indices have weightings based on market capitalisation, although this is very different from the way funds actually invest, says Lambert. For example, institutional investors in Europe are likely recently to have been overweight in France and underweight in Germany, but an index such as the FT/S&P would not have been able to reflect this as a peer group would have.

Ashton says none of the indices launched is ideal for performance measurement, and Callan, Bacon & Woodrow is in talks to design a better one, though no details are available yet.

State Street Global Advisers allows clients to create their own specialist industry and country benchmarks. SSGA and Reuters are two companies which can supply data resources for funds which want to go down the route of tailor-made indices.

This method has serious drawbacks. But Rob Barrett, head of indexation at SSGA London, hopes clients will opt to use a recognised benchmark, rather than making their own. He says an index created independently of the investment fund itself and one that is audited separately lends credibility to the performance numbers.

The narrow indices may be of little use for performance measurement. But the instruments based on them could be invaluble to fund managers, says Jonathan Seymour of Liffe. The FTSE Eurotop 100 may only comprise a narrow range of shares, but it has been specifically designed to track the broader FT/S&P Europe and MSCI Europe.

"[Products based on the Eurotop_100] allow fund managers to increase or decrease exposure to Europe as a whole in one single trade without having to trade different stocks or even a basket of stocks," says Seymour. "Because it tracks the benchmark very closely, it replicates the performance of the benchmark."

Although, for the purposes of performance measurement, an index should be as broad as possible, many investors in Europe may actually prefer to use a narrower one - at least to start with while they get used to the changes brought about by EMU.

"If someone has been investing over 80% of their assets in the Ibex 45 or Cac 40, is it now likely that they'll move up to an index with 750_stocks?" asks Huou of Merrill Lynch. "There's a learning curve there that we shouldn't ignore. In the longer term they will certainly distribute assets across a broader benchmark."

What will the ideal performance measurement benchmark for post-EMU European investment look like? Barrett believes clients will probably be looking for a European benchmark that excludes their own domestic market. But the trouble is nobody can say definitely what is going to happen when the single currency becomes a reality, he says. "No one knows what clients really want yet." Rachel Fixsen"

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