Benchmark design for an active investment process

Choosing the appropriate benchmark for active managers is a common debate among institutional investors. Norges Bank Investment Management has produced a “discussion note’ on the benchmark design for an active investment process, in which it introduces a flexible modelling framework that aims to incentivise each portfolio manager to utilise their stock-picking skill.

The benchmark design problem that NBIM addresses is not to do with the choice of weighting scheme to arrive at a more efficient beta representation of the market – such as fundamental weighting or risk parity.

Rather the active benchmark design problem it addresses is to construct a suitable custom benchmark on the portion to be carved out from the original market cap index to become the yardstick for the active manager to beat.

The discussion note points out that it could be argued that a cap weighted benchmark is not well suited for an active portfolio manager. One of the drawbacks is the lack of diversification in the index, due to the high concentration of weights in a small number of the largest securities. In a long only context, the NBIM paper, argues that this will generally limit the diversification benefits than enable active portfolio managers to express broader active views across names and size spectrum.

It says the practical implication is to build tailored research lists for the active managers according to their specialisations which form the universe of stocks for the design of the custom benchmark.

The key decisions in the sector benchmark design problem therefore become a choice of the number of names in the research list (universe) and the choice of the weighting scheme that is suitable for the investors’ active investment process.

In broad terms, it says, an optimally diversified sector benchmark should incentivise each portfolio manager to utilise their stock-picking skills and at the same time be able to enhance the fund’s overall performance in a scalable way.

More specifically the sector benchmark design has two defined objectives.

To maximise the potential for outperformance by limiting the number of benchmark names to allow portfolio managers to express high conviction positions while maintaining sufficient coverage of the sector. And secondly to embed diversification in the choice of weighting scheme. This can be achieved by moving away from market cap and towards equal-weighting to allow managers to take on meaningful active positions across their research lists.

To access the full research note, click here