Asset allocation and manager selection are two major concerns for most plan sponsors and asset owners. The fiduciary responsibility of trustees and sponsors is now more widely realised and has led to a welcome increase in debate and investigation around both issues. For example, the fundamental qualities of US Generally Accepted Accounting Principles (GAAP), which state that accounts should be relevant, reliable, comparable and consistent, also apply equally to the world of indexing.

Despite this, the matter of benchmark selection has not yet topped many meeting agendas, even though adverse effects from the selection of a benchmark that does not match investment requirements or that does not fairly measure the mandate given to a fund manager, could be easily resolved by more thorough consideration of the benchmark.

In spite of the recent bull run, possibly the major concern for asset owners and especially plan sponsors/pension fund trustees is the issue of how best to meet their liabilities in an uncertain climate.

This is driving an accelerating reassessment of whether a plan's stated objectives are correct and whether the current asset allocation is likely to meet the plan's overall objectives.

So although there has been plenty of debate about setting client-specific investment policy, there has been little comparable debate about how best to reflect this in actual mandates. In this article, we will look at why this third area is of such high importance, and why asset owners and their managers could benefit from allocating more time to a choice of benchmark.

We hope to show that by choosing from the
new, more closely aligned benchmarks, they could potentially optimise risk budgeting through better mandate definitions that are more tightly aligned with requirements.

The world of indexing has developed considerably in the past few years - such as with the introduction of new ways to benchmark existing and new asset classes, incorporating the same high standards of transparency and replicability as the traditional equity indices.

So when a plan sponsor is considering the move beyond core market cap-based equities, there is now a deep pool of expertise and specialised indexing tools available, to meet almost any requirement. Below we look at some different asset allocation options and the newest tools available to measure them.

 

Investment strategy indexing

The search for alpha and diversification has led many investors to diversify their equity holdings both away from equities and away from market capitalisation-based portfolios, to reduce the risk of over-exposure to possible bubbles in equity growth markets.

The largest plan sponsors in the US and Canada, and a growing number of investors in the rest of the world are becoming more and more interested in different investment strategies.

Moving away from the methodology of traditionally constructed benchmarks, investment strategy indexing uses underlying factors,
rather than market capitalisation, to weight companies in an index. The process behind these new methodologies combines elements of active fund management into a passive, rules-based index strategy by removing the price-related element of market cap-based indexing and replacing it with a measurement of company fundamental factors including, for example, cash flow, book value, sales and dividends.

FTSE calculates a number of investment strategy indexes, including the fundamentally weighted FTSE RAFI Series and the wealth weighted FTSE GWA Indices.

These are used internationally by some large funds, including State Street Global Advisors in Australia, AP3 in Scandinavia and some of the largest plan sponsors in North America. In addition, FTSE's custom calculation capabilities enable it to calculate equal-weighted indices for a number of clients, and a number of other weightings methodologies besides.

 

Customised benchmarks

A mismatch between mandate and benchmark favours neither the plan sponsor nor the fund manager, as it allows too much scope for risk to be adopted by the manager, or for unfair criticism of managers by plan sponsors. Where this is potentially the case, plan sponsors can turn directly to index providers for the creation of a specific, customised benchmark that more accurately matches the mandate to the fund manager.

This route has already been taken by plan sponsors whose mandates now have ethical or belief-based tilts that prohibit investing in tobacco or similar stocks, or avoid certain countries or companies investing in them.

It is important that these exclusions are incorporated in the benchmarks used for performance measurement. CalPERS, for example, often sets such mandates, and commissioned a FTSE custom index series that removes all tobacco and gaming stocks from the standard FTSE Global Equity Index offering. Fund management products related to these indexes are provided, delivered and supported in exactly the same way as the standard index products, making the use of the most accurate benchmark as easy as using a standard product. Other customisations typically include:

n compliance with specific country and regional regulatory requirements;

n country exposure limits;

n individual company size limits;

n removal or overweighting of sectors and countries;

n specific capitalisation limits - all companies smaller or larger than a specified size;

n companies with current or forecast dividend yields above a specified level;

n tax-adjusted to particular situations;

n implementing a currency hedge within the index, and

n capping.

The possibilities for benchmark design and construction are as wide ranging as individual mandates themselves. At FTSE, we believe that as asset owners review their asset allocation strategies it would be well worth their while to review their chosen benchmarks alongside.

Ongoing innovation means that new, cutting-edge benchmarks are being developed for a range of asset classes and investment strategies, and there is benefit for everyone in exploring them more thoroughly.

Paul Hoff is managing director, Asia Pacific, for FTSE Group

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