Key Points
- Investment management involves setting goals, selecting investments, and evaluating results.
- Portfolio construction is a common source of disappointment as it can lead to a deviation from the expected asset allocation.
- Benchmark misfit risk is often overlooked but can have a significant impact on portfolio performance.
- An assessment of the portfolio’s effective exposures can help identify and evaluate benchmark misfit risk.
- Misfit risk can lower volatility and add to risk but only modestly to return.
- A portfolio’s funds are more likely to undermine its asset allocation rather than deliver it.
- The responsibility for controlling benchmark misfit lies with the manager of the multi-asset portfolio.
- Focus should shift from alpha-first selection of individual funds to assembling a team of funds with aligned exposures.
This article is adapted from a version originally published in the fall issue of The Journal of Performance Measurement.
Investment management involves a three-part process: setting goals for risk and return, selecting investments, and evaluating the results. These activities are often carried out in isolation, leading to disappointment when expectations are not met. The portfolio construction process is a common source of disappointment as it can alter the asset allocation and deviate from what was expected.
Benchmark misfit risk, which results from the deviation of a portfolio’s market exposures from its intended asset allocation, is a problem that receives little attention. To address this issue, a process for identifying and evaluating benchmark misfit risk is outlined in this article.
Assessing Benchmark Misfit Risk
In order to assess benchmark misfit risk, it is necessary to evaluate the effective exposures of the portfolio’s funds. This involves conducting a regression analysis to determine the weightings of each segment in the portfolio, so that the return of the effective fund index has the highest correlation to each fund. By applying these weights to the allocation for each fund, the effective exposure of each fund to each market segment can be determined.
The results of this analysis show how each fund behaves, rather than how it looks or calls itself. By subtracting the total portfolio exposures from the asset allocation target weights, the effective active exposures for the portfolio, which are a key driver of tracking error, can be calculated.
By incorporating benchmark misfit risk into the analysis of the portfolio’s performance, a more accurate picture of the fund’s contribution to total return and total risk can be obtained. This analysis also reveals the contributions of misfit and selection to the portfolio’s excess return and tracking error.
Controlling Benchmark Misfit
Benchmark misfit is largely a result of actions taken by the portfolio’s underlying fund managers, who often seek excess return by deviating from their benchmarks. This return-seeking focus often works against the primary source of a portfolio’s returns: its asset allocation. Therefore, the responsibility for controlling benchmark misfit lies with the manager of the multi-asset portfolio.
To minimize benchmark misfit risk, the focus of the fund selection process should shift from an alpha-first selection of individual funds to assembling a team of funds whose aggregate set of effective exposures closely tracks the portfolio benchmark. This risk-aware approach tends to produce portfolios where tracking error is minimized and excess return is enhanced through diversification across the funds’ excess returns.
By adopting this approach, a portfolio’s information ratio can be significantly improved, providing a higher level of confidence in projections and expectations of excess return from the fund team.
Conclusion
Benchmark misfit risk is often overlooked in portfolio construction but can have a significant impact on performance. A comprehensive assessment of a portfolio’s effective exposures can help identify and evaluate this risk. By focusing on controlling benchmark misfit and assembling a team of funds with aligned exposures, portfolio managers can minimize tracking error and enhance excess return. This holistic approach to investment management can improve overall portfolio performance.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
Image credit: ©Getty Images/MANUEL FIL ORDIERES GARCIA
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