Investment professionals that utilize actively-managed strategies employ a process that takes into account the merit, quality, substance and value of a company before making an investment decision. A direct benefit of this type of due diligence is the fact that capital is allocated prudently among the securities that trade in the secondary capital markets. As a result of this process, proponents of active investment management believe that their work ensures the integrity and credibility of the system.

Prudent Allocation of Capital
In contrast to actively-managed investment strategies, passively-managed strategies systematically allocate money in a manner that replicates the makeup of a given index proxy. In aggregate, these index strategies are harmless to the system, provided that the total amount of assets under management is relatively small. However, as index funds gain greater market share, the negative ramifications to the secondary capital markets becomes significant, because proper due diligence is diminished, which in turn hinders the integrity and credibility of the system.

When this issue is contemplated at the aggregate level, a strong case can be made that the free-rider methodology employed by the use of index funds is a violation of the prudent investor guidelines, and if utilized to a large degree, it's detrimental to the secondary capital markets. Based on this premise, representatives of publicly traded companies, public policy makers, regulatory authorities and individual investors should begin to weigh the negative long-term impact that index strategies have on the secondary capital markets, and consider the endorsement of a process that curtails the use of passive management over active management.

Common Benchmarks Used by Investors
When comparing the performance of an actively managed investment strategy to an index, it is important to ensure that a valid benchmark proxy is utilized. Let's begin by listing the seven primary benchmarks employed by investors, and then discuss their efficacy as a valid benchmark proxy.

  • Absolute benchmark proxies such as an actuarial rate of return
  • Manager universe proxies
  • Broad market indexes
  • Style indexes
  • Factor-based-model indexes
  • Returns-based indexes
  • Custom security-based indexes

Valid Benchmark Criteria
Active investment management receives a significant amount of criticism from those investors that believe risk-adjusted performance is worse for actively-managed funds than for index funds. Unfortunately, this conclusion may be wrong due to the fact that incorrect benchmark proxies have been used to compare performance and can result in a misrepresentation of results.

To address the complexity associated with the comparison of investment performance between investment vehicles and benchmark proxies, the CFA institute has published a list of criteria that a benchmark must meet in order to be considered valid. According to the CFA, a benchmark must be:

A measurable benchmark can be quantified in numerical terms over a give time horizon. Each of the seven benchmarks listed above meets this criterion. However, there are benchmarks in which the underlying assets that make up the index are infrequently traded. In such cases, a benchmark proxy cannot be accurately measured. As a result, a comparison of the performance of an actively managed strategy in relation to this type of benchmark is not valid.

An investable benchmark means that it is possible to forgo the use of active investment management and rely on an index fund to replicate performance. Absolute performance indexes, manager universe benchmarks, and factor-model-based benchmarks violate this criterion, because there is not a comparable investment vehicle with these types of strategies. As a result, a comparison of the performance of an actively managed strategy to these types of benchmarks is not valid.

The appropriateness criterion ensures that the benchmark correctly measures the performance of the investment strategy. Broad-market indexes typically violate this criterion, because most investment strategies have a tailored focus. As a result, a comparison of the performance of an actively managed strategy in relation to a broad-market index is not valid, unless the investment manager utilizes an actively managed broad-market investment strategy that is comparable to the index.

An unambiguous benchmark is one in which its underlying constituents are known, and their weightings in the makeup of the index is clear. Style indexes typically violate this criterion, because performance tends to be contingent upon the definition of style used by the index provider. As a rsult, a comparison of the performance of an actively-managed strategy in relation to a style index is not valid, unless it is verified that both the index provider and investment manager define style in the same manner.

Reflective of Current Investment Opinion
A benchmark which is reflective of current investment opinion is one in which the investment manager has current investment knowledge of the securities or factor exposures that make up the benchmark. Factor-based models typically violate this criterion, because investment managers do not think in terms of factor exposures when designing their investment strategies. As a result, a comparison of the performance of an actively-managed strategy in relation to a factor-based-model is not valid.

Specified in Advance
Specification means that the makeup of the benchmark is disclosed prior to the start of the evaluation period. Median manager benchmark proxies violate this criterion, because the median manager can only be established on an ex-post basis, and because the median manager will differ from one time period to the next. In addition, returns-based indexes violate this criterion, because the regression relation used to define the beta coefficients for each asset class that makes up the benchmark universe is not constant, which in turn means that it cannot be specified in advance. As a result, the performance of an actively-managed strategy, in relation to a median manager index, or returns-based index is not valid.

Able to Be Owned
The ability to own an index means that the benchmark should be integral to the investment process and procedures of the investment manager. Returns-based indexes typically violate this provision, because an unconstrained returns-based index typically produces unacceptable exposure levels to various asset classes. As a result, a comparison of the performance of an actively-managed strategy to the performance of a returns-based index is not valid.

Benchmarks that Meet the Validity Criteria
There are three types of indexes that meet all seven benchmark validity criteria. First, a broad-based index may serve as an appropriate benchmark, provided it is used as a proxy for a manager that utilizes a similar broad-based strategy. Second, a style-based index may serve as an appropriate benchmark, provided the makeup of the style index is defined in the same manner as the strategy employed by the active investment manager. Of course, the performance of both of these types of indexes should include a small reduction in performance in order to reflect a modest management fee that is required to manage money.

In addition, a custom security-based index meets all seven of the benchmark criteria. Custom security-based benchmarks are simply the research universes utilized by an investment management team that is weighted in a particular manner in order to calculate composite performance. The weightings of the securities that make up the index can be equally distributed, distributed in relation to market capitalization, or distributed in a customized fashion.

The Bottom Line
While there are many who dismiss the potential benefits of active management, investors should recognize that active investment management ensures that capital is allocated properly and in conformance with the prudent investor guidelines. In addition, there can be long-term negative ramifications to the secondary capital markets if index funds gain a greater share of the market. Finally, investors should understand that there are proper guidelines that need to be followed when comparing the performance of an actively-managed investment strategy with a benchmark proxy.

Related Articles
  1. Mutual Funds & ETFs

    Passively Managed Vs. Actively Managed Mutual Funds: Which is Better?

    Learn about the differences between actively and passively managed mutual funds, and for which types of investors each management style is best suited.
  2. Mutual Funds & ETFs

    The Democratization of the Hedge Fund Industry

    The coveted compensations of hedge fund managers are protected by barriers of entry to the industry, but one recent startup is working to break those barriers.
  3. Retirement

    Two Heads Are Better Than One With Your Finances

    We discuss the advantages of seeking professional help when it comes to managing our retirement account.
  4. Professionals

    A Day in the Life of a Hedge Fund Manager

    Learn what a typical early morning to late evening workday for a hedge fund manager consists of and looks like from beginning to end.
  5. Mutual Funds & ETFs

    American Funds' Top Funds for Retirement

    Planning for retirement in this economic and investment environment is far from easy. American Funds might offer an answer.
  6. Investing Basics

    5 Tips For Diversifying Your Portfolio

    A diversified portfolio will protect you in a tough market. Get some solid tips here!
  7. Entrepreneurship

    Identifying And Managing Business Risks

    There are a lot of risks associated with running a business, but there are an equal number of ways to prepare for and manage them.
  8. Active Trading

    10 Steps To Building A Winning Trading Plan

    It's impossible to avoid disaster without trading rules - make sure you know how to devise them for yourself.
  9. Mutual Funds & ETFs

    Buying Vanguard Mutual Funds Vs. ETFs

    Learn about the differences between Vanguard's mutual fund and ETF products, and discover which may be more appropriate for investors.
  10. Mutual Funds & ETFs

    ETFs Vs. Mutual Funds: Choosing For Your Retirement

    Learn about the difference between using mutual funds versus ETFs for retirement, including which investment strategies and goals are best served by each.
  1. How do I calculate the loan-to-value ratio using Excel?

    Investors have a variety of pooled fund investment options, including mutual funds and money market funds, that can meet ... Read Full Answer >>
  2. How liquid are Vanguard mutual funds?

    The Vanguard mutual fund family is one of the largest and most well-recognized fund family in the financial industry. Its ... Read Full Answer >>
  3. Which mutual funds made money in 2008?

    Out of the 2,800 mutual funds that Morningstar, Inc., the leading provider of independent investment research in North America, ... Read Full Answer >>
  4. Does OptionsHouse have mutual funds?

    OptionsHouse has access to some mutual funds, but it depends on the fund in which the investor is looking to buy shares. ... Read Full Answer >>
  5. Should mutual funds be subject to more regulation?

    Mutual funds, when compared to other types of pooled investments such as hedge funds, have very strict regulations. In fact, ... Read Full Answer >>
  6. How do mutual funds work in India?

    Mutual funds in India work in much the same way as mutual funds in the United States. Like their American counterparts, Indian ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Take A Bath

    A slang term referring to the situation of an investor who has experienced a large loss from an investment or speculative ...
  2. Black Friday

    1. A day of stock market catastrophe. Originally, September 24, 1869, was deemed Black Friday. The crash was sparked by gold ...
  3. Turkey

    Slang for an investment that yields disappointing results or turns out worse than expected. Failed business deals, securities ...
  4. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
  5. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...
  6. Black Tuesday

    October 29, 1929, when the DJIA fell 12% - one of the largest one-day drops in stock market history. More than 16 million ...
Trading Center