Determining the Optimal Benchmark for Funds

Ask the asset manager?

October 2023. Reading Time: 10 Minutes. Author: Nicolas Rabener.
SUMMARY

  • Identifying the right benchmark for a fund or portfolio can be difficult
  • Many common metrics like correlation or betas do poorly for benchmark selection
  • Combining metrics is more effective

INTRODUCTION

Is gold the right benchmark for gold miners? Although these companies focus on excavating the precious metal, there are plenty of operational issues like staff strikes, collapsing mines, or politics that can affect these beyond the changes in the gold price.

How about REITs? They own real estate where valuations move at a glacial pace, but trade as public companies and are therefore subject to the whims of stock market investors, of which some only care about their daily P&L.

Capital allocators can ask the asset managers for the most appropriate benchmarks for their investment products, but fund managers have an incentive to select the ones that make them look best, so are biased. Choosing benchmarks manually is challenging as there are more than 3 million indices, so automating the benchmarking process is more sensible (try Finominal’s Alpha Analyzer for this).

In this research article, we will evaluate a few simple approaches for systematically selecting the most appropriate benchmarks.

METHODOLOGY

We select 10 random funds that represent various asset classes like gold and strategies like momentum.

Theoretically, we could use the 3 million indices as the data set for benchmarks, but most of these are unknown and do not represent what most investors consider as benchmark indices. Given this, we select 40 well-known indices like the S&P 500 and aim to select one of these as the optimal benchmark for each of the 10 funds based on different metrics. We use a one-year lookback for all metrics, which is not particularly long, but does allow us to consider ETFs and mutual funds that were listed recently.

CORRELATION

The first approach we utilize is simply to calculate the one-year correlation of each of the 10 funds and then select the benchmark index with the highest correlation as the most appropriate.