Performance Benchmarks for Institutional Investors: Measuring, Monitoring and Modifying Investment Behaviour

The two main types of benchmarks used in the UK are external assetclass benchmarks and peer-group benchmarks. Peer-group tracking is much more prevalent with pension funds and mutual funds than with life funds. However, the use of customized benchmarks that reflect the specific objectives set by particular funds is increasing. Benchmarks influence the type of assets selected and, equally significantly, the type of assets avoided. Peer-group benchmarks have a tendency to distort behaviour, particularly when combined with a fee structure that does not promote genuine active management. The outcome tends to be herding and closet index matching. The main alternatives to peer-group benchmarks are: single-index benchmarks with time-varying coefficients, multiple-index benchmarks and fixed benchmarks. The first two alternatives have recently been discussed in the academic literature but have yet to catch on in the practitioner community. There are also benchmarks based on liabilities. These are generally related to real earnings or consumption growth or to the discount rate on liabilities. Explicit liability-based benchmarking is currently not very common, but is likely to become so in the light of both the increasing maturity of pension funds, various regulatory and financial reporting developments, and the Myners Review of Institutional Investment. Liability-driven performance attribution explicitly takes the liabilities into account. Performance benchmarks for institutional investors 109 The US has similar external asset-class and peer-group benchmarks as the UK. Other countries tend to use fixed or bond-based benchmarks. In conclusion, we find that benchmarks are important, but so are fee structures. They can either provide the right incentives for fund managers or they can seriously distort their investment behaviour.