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T he attitude of portfolio managers to benchmarks of market performance is constantly evolving.

Many active managers still largely track indices with the aim of outperforming them by certain percentages, says Gaurav Shah, managing director of the global product strategy team at Credit Suisse Asset Management. But in the past few years, there has been a move among active managers towards an “unconstrained” approach to managing portfolios.

“Unconstrained portfolios are constructed with no reference to market capitalisation weighted benchmarks; that is, the weight of a stock in an index would play no part in the weight of a stock in a given portfolio,” he says.

These would offer managers more scope to invest in stocks because they think they are attractive than would an index-hugging approach, he says.

The development comes amid a growing debate about whether active managers are generating the extra return that many clients expect.

“There is probably more debate today on whether active managers are generating enough alpha or not,” says Theodore Niggli, executive director of MSCI Barra.

He says indices provide a useful benchmark for active managers, but “outperformance is also a function of how much leeway is given to the active manager in their investment mandate”.

Lillian Goldthwaite, head of equities at FTSE, says active managers are increasingly finding different ways to use indices as part of their investment strategies.

For instance, she says, the launch in 2005 of the FTSE GWA index series was in response to demand for alternative indices that break with traditional price-weighted design. These indices try to capture a company’s wealth creation in the form of its net income, cash flow and book value – and not market capitalisation.

“It is an enhanced methodology that captures strategies traditionally employed by active managers and such indices can be used by both active or passive managers as a means to consistently enhance returns and reduce risk.”

Nonetheless, indices – or benchmarks – remain an integral component of managers’ approach, whether the aim is to outstrip a particular index or not.

“Even in a purely unconstrained environment, managers still need to look at benchmarks as reference points,” says Mr Shah. “Some indices still give clients something meaningful to measure the manager’s performance against.”

“Choosing the right benchmark is very important to establish the volatility and return parameters for managing a portfolio. Making the right choice also depends on factors individual to each client and strategy.”

Indeed, investment management is closely based on guidelines that have been discussed and agreed with the client, including what the terms are for risk profiles, returns, capital growth expectations and cash flow requirements.

This means that many managers largely track specific indices and try to outperform them. For complex, multi-asset portfolios, the manager might construct a benchmark that combines different indices, including equity and bond indices.

While every index in each asset class provides something different, there are some indices that are seen as industry standards.

Fixed income managers often look at indices provided by bulge-bracket investment banks including Lehman Brothers, Merrill Lynch and Citi. For equities, managers look at the MSCI series of indices and the S&P, while for commodities managers often use indices by Goldman Sachs, Dow Jones and Deutsche Bank.

But Darrell Riley, at T Rowe Price, says: “There are literally hundreds of benchmarks out there and what the active manager decides to use depends on what the client is looking for and the need to satisfy certain requirements, such as tracking error targets or liability matching.

“One manager of a large-cap US equity strategy may replicate the characteristics of a particular index, such as the Russell 1000, and another managing a similar strategy may be generally aware of the index with no attempt to replicate its characteristics.”

The client’s time horizon is also important. A bond portfolio requiring high liquidity might use a three-month Treasury index as a benchmark rather than something that contains fewer liquidity issues and exhibits greater interest rate sensitivity. Mr Shah says there are several factors when deciding on benchmarks for his group’s long-only enhanced index portfolios, including whether the benchmark contains the full set of securities available for investment, whether the names and weights of securities – along with rules governing the benchmark – are well defined and whether the benchmark is priced daily.

Mr Riley says: “In some cases, it doesn’t matter what indices are used. What matters a lot is that the managers know how the active portfolios they are running differ from the benchmarks and they understand the active risks they are taking.

“There are different combinations of benchmarks that active managers can use. It’s not a static world and investors can slice it in several different ways.”

But he adds: “The worst thing a manager can do is to underperform an index and not give the client the asset class they paid for.”

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