Last week, our most-read article was a piece on evaluating your benchmarks by longtime CIO Tony Waskiewicz, formerly of Mercy. One of our readers was intrigued and asked to further the conversation.
Thanks, Tony. This is a great recommendation for benchmarking the portfolio. I’m curious to hear your thoughts on how to benchmark alternative investments. Would you use the same long-only benchmarks or do you use alternative benchmarks? — Ron
Tony was kind enough to illustrate how his process might work for alternatives, and we thought it was worth continuing the conversation in our newsletter, just in case many more of our readers would also find it useful.
Investable benchmarks for alternative investments, similar to traditionally used benchmarks for alternatives, have limitations; however, it is possible to have a real basis upon which to determine the value-add of a team/program.
For hedge funds, there are two methods to consider. First, and the preferred method, is to use the HFRX investable commingled funds as the hedge fund benchmark. The HFRX products are investable and have ticker symbols, similar to US Securities and Exchange Commission (SEC) registered funds, which can be found on various hedge fund databases including at: https://www.hedgefundresearch.com/indices.
If the HFRX method is chosen, I would recommend breaking out the portfolio’s hedge fund composite to its sub-strategies and then using the sub-strategy investable fund as the benchmark. For example, the hedged equity part of your portfolio would be benchmarked to the HFRXEH vehicle. Your Macro allocation can be benchmarked to the HFRXM vehicle and the Relative Value composite can be benchmarked to HFRXRVA, and so on.
The challenge to this method is that the investable products are not very strong performers, so they become somewhat of an easy metric to outperform. Very few institutions would actually invest in these vehicles, so stakeholders might object to the idea of having a benchmark that would never be used by the institution. Those objections are reasonable, but I believe that having a viable, investable product as a benchmark takes priority over the other issues.
The second method could be to identify a professionally managed, third-party hedge fund-of -funds product as the benchmark. The idea would be that an institution could consider hiring a particular fund-of-funds manager in lieu of maintaining an in-house invest team. This possible third-party solution is a viable approach and therefore the returns of the third party fund-of-funds product could be used as the benchmark (or a fair basis upon which to evaluate the value-add of the investment program).
Investable benchmarks for private investments are easier and can be done just as you suggest in your question, specifically, by adding a return premium to the selected investable public market benchmark. The assigned return premium is, of course, the excess return expected by giving up liquidity. This range is typically 2%-5% for equity and 1%-3% for credit.
For example, an investor might assign a 200 basis point (bps) premium to the small-cap ETF, IWM, as the investable benchmark for its buyout portfolio. The idea would be that the institution could actually buy the IWM ETF and could do so with leverage to obtain the ETF return plus 200 basis points. Or it could make commitments to private equity buyout funds. Either approach is viable, and that is the point of the investable benchmark exercise—it provides a way to compare two viable options (therefore produces a real basis to evaluate the value-add of the team/function).
An institution could do the same for its private credit exposure. It could lever up the HYG ETF to get to a HYG plus 200 basis point return. Or it could make commitments to private credit vehicles. Both approaches can be used, so it is fair to use the HYG + 200 as the benchmark for the private credit allocation of the portfolio.
I hope this helps! Please let me know if you have further questions.
We know it’s quite the year to consider benchmarks. Continue to email us if you have further questions, and good luck!