Performance Benchmarking: Evaluating Alternative Investments

21.11 Performance Benchmarking

In the realm of investment management, performance benchmarking serves as a critical tool for evaluating the success of investment strategies. This is particularly true for alternative investments, where traditional benchmarks may not always apply. In this section, we will delve into the concept of benchmarking, its significance in performance evaluation, and the nuances of selecting appropriate benchmarks for alternative strategy funds, with a focus on the Canadian financial landscape.

Understanding Benchmarking

Benchmarking is the process of comparing a fund’s performance against a standard or benchmark to evaluate its effectiveness. This standard could be a market index, a peer group, or a custom benchmark tailored to the fund’s specific strategy. The primary goal of benchmarking is to provide a reference point that helps investors assess whether a fund manager is adding value relative to the risk taken.

In the context of alternative investments, benchmarking becomes more complex due to the diverse nature of these strategies, which can include hedge funds, private equity, real estate, and commodities. Unlike traditional equity or bond funds, alternative investments often pursue absolute returns, meaning they aim to generate positive returns regardless of market conditions.

The Role of Benchmarking in Performance Evaluation

Benchmarking plays a pivotal role in performance evaluation by:

1. Providing Context: It offers a frame of reference for assessing a fund’s performance, helping investors understand whether the returns achieved are satisfactory given the market environment and the fund’s risk profile.

2. Facilitating Comparison: By comparing a fund’s performance to a benchmark, investors can gauge how well the fund manager is performing relative to peers or the broader market.

3. Enhancing Accountability: Benchmarks hold fund managers accountable for their investment decisions, encouraging them to adhere to their stated investment objectives and strategies.

4. Guiding Investment Decisions: Investors can use benchmarking to make informed decisions about allocating capital, rebalancing portfolios, or selecting fund managers.

Selecting Appropriate Benchmarks for Alternative Strategy Funds

Choosing the right benchmark for alternative strategy funds is crucial, as these funds often have unique investment objectives and risk profiles. Here are some considerations for selecting appropriate benchmarks:

1. Alignment with Investment Objectives: The benchmark should reflect the fund’s investment objectives. For alternative funds focused on absolute returns, benchmarks that track absolute performance, such as cash plus a spread, may be more appropriate than traditional market indices.

2. Risk Profile Matching: The benchmark should have a risk profile similar to that of the fund. This ensures that performance comparisons are meaningful and reflect the fund’s risk-adjusted returns.

3. Relevance to Strategy: The benchmark should be relevant to the fund’s strategy. For example, a hedge fund employing a long/short equity strategy might use a combination of equity indices and cash benchmarks to reflect its market exposure and hedging activities.

4. Consideration of Market Conditions: Alternative funds often perform differently in various market conditions. Benchmarks should account for these variations to provide a fair assessment of performance.

Practical Examples and Case Studies

Example 1: Canadian Pension Fund

Consider a Canadian pension fund that invests in a diversified portfolio of alternative assets, including real estate and private equity. The fund’s objective is to achieve a stable return above inflation. An appropriate benchmark might be the Consumer Price Index (CPI) plus a fixed percentage, reflecting the fund’s goal of preserving purchasing power while generating additional returns.

Example 2: Hedge Fund with Absolute Return Strategy

A hedge fund based in Toronto focuses on generating absolute returns through a market-neutral strategy. The fund manager might choose a benchmark such as the Canadian Overnight Repo Rate Average (CORRA) plus a spread, which aligns with the fund’s objective of achieving positive returns irrespective of market direction.

Challenges and Best Practices in Benchmarking

Common Challenges

• Lack of Suitable Benchmarks: Many alternative strategies lack readily available benchmarks, making it difficult to find an appropriate standard for comparison.
• Complexity of Strategies: The diverse and complex nature of alternative strategies can complicate the benchmarking process.
• Market Volatility: Alternative funds may be more sensitive to market volatility, affecting their performance relative to benchmarks.

Best Practices

• Custom Benchmarks: Consider creating custom benchmarks that better reflect the fund’s strategy and objectives.
• Regular Review: Periodically review and adjust benchmarks to ensure they remain relevant and aligned with the fund’s evolving strategy.
• Transparency: Clearly communicate the chosen benchmark and the rationale behind its selection to investors.

Canadian Financial Regulations and Resources

In Canada, investment funds are subject to regulations by the Canadian Securities Administrators (CSA) and the Canadian Investment Regulatory Organization (CIRO). These bodies provide guidelines on performance reporting and benchmarking practices.

For further exploration of benchmarking and performance measurement, consider the following resources:

• Books: “Investment Performance Measurement” by Philip Lawton and Todd Jankowski offers comprehensive insights into performance evaluation techniques.
• Websites: Morningstar on Benchmarking provides valuable information on benchmarking practices and tools.

Conclusion

Performance benchmarking is an essential component of evaluating alternative investments, providing investors with the tools needed to assess fund performance and make informed decisions. By selecting appropriate benchmarks and adhering to best practices, investors can better understand the value added by fund managers and optimize their investment strategies within the Canadian financial landscape.

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