The Benchmark

From aiCIO Magazine's Summer Issue: Benchmarks are now etched in the stone pillars of performance.  

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In a land where the benchmark is king, who decides where to place the crown? The term benchmarking can be attributed to surveyors in the early 1800s who would etch a mark in solid stone to determine a reference point for their future work. They theoretically could abandon their work, possibly for months at a time, and still return to the same spot. It could be argued, then, that benchmarking gave one small push to the pendulum that placed building between an art and a science.

Fast forward to the world of institutional investing in 2011, where benchmarks are now etched in the stone pillars of performance. Many funds—especially those, like Canadian and European-based pensions, that house large proprietary asset management teams—use these reference points to evaluate and compensate for performance against peers and policy portfolios, understand cost, communicate to stakeholders, and gain insight into best practices. An uncontroversial instrument, it would seem; however, far from a panacea, benchmarking systems increasingly are fraught with controversy as to their efficacy, prominence, and sway.

This controversy has revolved largely around the use of benchmarks to justify performance bonuses which, when based on numerous years’ performance, often leads to the awkward moment when a fund’s performance is down but its managers are still receiving millions. When this happens, as it did with many Canadian funds in 2008, the benchmark itself often comes under fire.

One of the firms taking heat for providing justification—in a pejorative sense—for large bonuses is CEM Benchmarking of Toronto, Canada. The 1991 brainchild of pension guru Keith Ambachtsheer and John McLaughlin, the firm currently has a list of 350 blue chip corporate and government clients from around the globe, totaling nearly $3 trillion in assets from pension funds, endowments/foundations, and sovereign wealth funds. “CEM Benchmarking is an excellent company, [and is] well-respected in the pension industry,” says Leo Kolivakis, himself a respected pension industry analyst out of Canada. “However, my biggest beef is that firms like CEM are not discussing performance benchmarks and comparing them across funds, nor are they analyzing the use of leverage across funds.” In short, Kolivakis feels that CEM is not painting a complete picture of how pension funds garner their return—and that this can and sometimes does lead to unjustified payment for pension chief investment officers and other employees.

CEM disagrees. “Our global databases provide more than 20 years of detailed data on investment holdings, performance, risk, and actual incurred costs that are broken down by oversight, internal investment management, external investment management, and other costs such as those for custodial and consulting services,” says CEM Vice President Jody Macintosh. The company’s benchmarking methodology focuses on their clients’ policy allocation rather than their actual allocation, she says, adding that the firm relies on clients to provide the benchmarks they use for each of the asset classes in their policy allocation. CEM then applies its own data-cleaning rules to ensure there is a reasonable fit between the benchmarks clients provide for asset classes, the underlying market universe of opportunities, and corresponding risk and return characteristics. For example, Macintosh asserts, benchmarks for public asset classes must be investable and correspond to the asset class—for example, the S&P 500 for large-cap U.S. equity, the Russell 2000 for small-cap U.S. equity.

Yet, it generally is not in public equity benchmarking where controversy has arisen. Instead, it is with the proprietary alternative asset management units at large ex-America funds that people like Kolivakis see the most potential for problems. This makes intuitive sense: Private market benchmarks can be problematic because of the lack of accepted standard benchmarks and valuation lag issues. “A suitable alternative would be cumulative IRR over a 10-year period,” Kolivakis says. “I believe in cash-on-cash results, but I understand why they use benchmarks. It’s an easy way to measure relative performance, but the problem is everyone uses different benchmarks for private markets.”

Macintosh admits that there are more issues in this space. “The biggest challenge we face is getting participants to provide standardized, comparable data in an increasingly complex investment environment,” she says. “For example, as the breadth of investment strategies continues to expand and participants seek increasingly complex strategies such as using derivatives and overlays, the lines between asset classes become blurred and it becomes more difficult to do apples-to-apples comparison.”

Of course, Macintosh, like any good businesswoman, sees opportunity in the complexity. “We are seeing greater interest in alternative asset classes including private equity, real estate, infrastructure, [and] hedge funds,” she says. “We help funds to see what other leading funds around the world are doing in this area, as well as how they are doing it. For example, if a fund chooses to invest in an alternative asset class, is it buying an external product or building internal expertise? We are beginning to see a trend toward more internal management, especially among traditional asset classes. This is fostering a greater interest in compensation structures as funds must compete with investment managers for talent.”

It is easy to find solace in the concept of a benchmark—but this solace isn’t always justified. Proponents of this practice are looking to make more calculated moves to put their minds at ease, but the reality is that they are looking for consistency in an inconsistent world. When surveyors etched their benchmarks in the stone, they could be reasonably sure that the notch they carefully placed wasn’t going to waver. Pension fund benchmarks involve extremely more complex permutations. In a few words: There is no solid stone. —Jordan Milne