The use of benchmark indices
A strategic benchmark index is an expression of the owner’s investment preferences. It is rooted in the fund’s objectives and should reflect the strategic role of the individual asset classes in the fund. Above all, the strategic benchmark index defines an investment direction and a risk tolerance.
The strategic benchmark index for a large public fund should be chosen from leading and readily available indices to maximise transparency. Most commonly used indices aim to cover the investable universe in an asset class and weight the different securities included in the index on the basis of their market value. These market indices are designed to serve as a yardstick for a manager’s implementation of a management mandate and are not tailored to an individual fund’s specific objectives and characteristics.
An operational benchmark portfolio allows these commonly used indices to be tailored more closely to a fund’s objectives and characteristics. The benchmark portfolio will move away from leading market indices towards a higher degree of customisation. This customisation requires proximity to the markets invested in, and decisions must take account of fundamental and structural factors in these markets.
The aim of the operational benchmark portfolio is to achieve a better trade-off between expected return and risk after costs. The limits set in the management mandate can still be linked to the strategic benchmark index. Deviations between the benchmark index and the benchmark portfolio will then draw on the risk limits in the investment mandate in the same way as other investment decisions, but may differ in size, nature and timeframe from what would normally come under the heading of active management.
The strategic benchmark index set by the Ministry of Finance
In its Mandate for the Management of the Government Pension Fund Global, the Ministry of Finance has defined a strategic benchmark index consisting of two asset class indices – an equity index and a bond index – in set proportions. No good market indices are available for the fund’s third asset class, real estate, and so it is not discussed further in this article.
The benchmark indices set by the ministry are based on market indices from leading index suppliers, which helps ensure transparency and verifiability. The index defines an investment direction and reflects the owner’s risk tolerance. The equity benchmark is the FTSE Global Equity Index Series All Cap index, while the benchmark for bond investments is composed of indices from Barclays Capital.
The composition of the index will move away from the fixed weights in the strategic benchmark index over time due to different movements in value between regions and asset classes. The ministry therefore calculates an actual benchmark index, which can be very different to the strategic index at times. The difference between the strategic and actual benchmark indices from the ministry will also be affected by how inflows of new capital and the rebalancing of the fund are handled. The actual benchmark index is the one used to calculate excess return and risk. The investment decisions as part of the procedures for inflows and rebalancing are not measured in this structure.
The operational benchmark portfolio used by NBIM
NBIM’s operational benchmark portfolio aims to further adapt the strategic benchmark index to the fund’s objectives – safeguarding wealth and long-term purchasing power – and distinguishing characteristics – primarily its size, long-term outlook and absence of short-term liabilities. It addresses the methodological weaknesses and unnecessary complexity of the strategic benchmark index, reflects adjustments to the fund’s investment universe, and aims to take account of structural changes in the markets, alternatives to marketweighting, and time-varying risk premiums.
Commonly used benchmark indices have a number of methodological weaknesses in terms of the different asset classes’ strategic role in the fund. Two examples on the fixed-income side are the automatic exclusion from the index of bonds whose credit rating drops below a certain level and bonds that have less than a year to maturity. An example on the equity side is the adjustment of a company’s index weight to allow for shares that are not freely tradeable (free-float adjustment).
The diversification gain from holding all stocks and bonds included in broad benchmark indices is limited. The key risk characteristics of the strategic benchmark index can be recreated with a much smaller number of securities, which helps reduce the complexity of the portfolio and the cost of management. In the operational benchmark portfolio, we have removed some types of structured bonds, such as US mortgage-backed securities, and we have set a higher threshold for the inclusion of new bond issues, reflecting the size of the fund.
Leading market indices represent the investment universe of a typical investor. In some cases, however, a large sovereign investor such as the fund will have different investment options. The operational benchmark portfolio adjusts the investment universe on the basis of risk assessments relating to operational risk and legal protection as well as various forms of regulation. NBIM has set up a committee to decide which markets and securities the fund may be invested in, and this is reflected in the operational benchmark portfolio. Pakistan, for example, is not approved for equity investments as it is considered to provide inadequate protection for shareholders, even though this market is included in the strategic benchmark index. Similarly, investments in the Mexican financial sector have been excluded from the operational benchmark portfolio because foreign sovereign funds are not permitted to hold shares in Mexican financial institutions. An equivalent example on the bond side is the capital restrictions on government bonds in Taiwan, only in this case the operational benchmark portfolio is broader than leading market indices as these restrictions are not a limiting factor for the fund.
Commonly used market indices will reflect structural changes in the issuance of new securities. Through adjustments to the operational benchmark portfolio, we can make more appropriate allowance for such changes. One example is changes in bond issuance in various parts of banks’ capital structure as a result of new regulation in the financial sector, which should not necessarily be part of the fund’s investment strategy. Another example is increased issuance of government bonds in countries where public finances are under pressure, which can impact on the currency, credit and liquidity characteristics of market indices without necessarily being in line with the fund’s long-term aims.
Market indices weight securities on the basis of their market value. This market-weighting is not necessarily the best option for the fund given its particular characteristics. Other weighting methods may help improve the long-term trade-off between risk and return in the fund, especially when it comes to equities. On the fixed-income side the principle of market-weighting means that borrowers issuing large volumes of bonds have a greater weight in the benchmark index. In a GDPweighted portfolio, each country’s share is based on its economic output rather than its borrowings. The portfolio’s currency mix will be affected partly by which currencies are included and partly by the weights they are given. Government bonds in emerging markets have been assigned a larger weight in the operational benchmark portfolio to reflect the fund’s objective of safeguarding long-term international purchasing power.
Investment opportunities and risk premiums vary over time and along different dimensions. In some cases, the fund may be particularly well-placed to exploit these variations. It may therefore be natural to include time variations in some risk premiums in an operational benchmark portfolio, such as exposure to small companies or variations in credit premiums. This could be a way of taking advantage of the fund’s long-term outlook and absence of short-term payment obligations.