The sad reality of the local benchmarking scene

Russell Investments New Zealand has blasted the benchmarking practices of New Zealand fund managers and institutional investors in a new report.

Wednesday, February 8th 2023, 6:03AM

The review found that when it comes to benchmarking of single asset class, fully invested and liquid (‘traditional’ or marketable securities) portfolios and funds, local practices often serve fund managers far better than their clients. It accuses fund managers of choosing easy-to-beat benchmarks for single asset class funds, and collecting fees without adding any value.

Russell NZ director Matt Arnold who authored the report says, for most traditional asset classes and market segments, there is no need to adopt anything other than standard ‘off the-shelf’ indices which are independently researched and robust as benchmarks. However, many local retail investors are in funds with inappropriate, self-selected performance fee benchmarks, leading to hedge fund-like fees for run-of-the-mill equity and diversified funds.

Beta returns, alpha fees

“The most glaring example involves the use of benchmarks that bear little or no resemblance to the underlying assets of the fund or portfolio. Often used as a performance fee hurdle, ‘cashplus’ benchmarks for fully invested equity portfolios represent the most egregious example of benchmark mismatch, with the impact on investors being that they end up paying hedge fund-like fees for what amount to plain vanilla, run-of-the-mill equity funds”, he says in the report.

He describes the “sad reality” of the local scene in which many fund managers have used targets as low as 3% or 4% given the ultralow cash rates of the last decade or more, which is an absurdly low performance fee hurdle for funds investing wholly in asset classes regularly delivering double-digit returns.

“Under many of the fee arrangements employed locally, simple New Zealand and global equity index funds would have ended up attracting 2%, 3% or even more in fees in more than 50% of the calendar years since 2009. This is clearly ridiculous and highlights how one-sided these arrangements are in practice.”.

The report also notes some improvement last year, perhaps due to greater scrutiny from the Financial Markets Authority, with some firms dropping performance fees for retail investors, and others increasing their excess return targets or introducing high water marks and caps.

“Several funds appear to have moved away from cash benchmarks entirely in favour of target market indices, such as the S&P/NZX 50. Nonetheless, we see no reason why performance fees should be so common locally, when in other large markets they are seldom found in simple, long-only funds for retail, ‘mum and dad’ investors.” He says such fees are rarely, if ever, accepted by institutional investors.

Examples of local practices that fall short include: using the incorrect return index, deducting fees from an index return to reflect ‘costs’, using an Exchange Traded Fund (ETF) as a benchmark, and using inappropriate indices that don’t reflect the underlying assets.

ESG and RI tinkering?

With the continued growth of responsible investment (RI), where investors shun certain types of funds such as tobacco or fossil fuels, the report recommends that fund managers stick to broad market benchmarks rather than tinker with benchmarks to try to reflect any restrictions or exclusions.

Fund and portfolio benchmarks should represent the starting point, or neutral stance, rather than the end state, says the report. Where certain securities have been excluded, this needs to be captured and through using broad, standard market capitalisation weighted indices, it is clear what impact these decisions are having on total portfolio results.This is preferable to removing those securities or heavily modifying the benchmark to reflect the portfolio.

The report allows some exceptions such as in the case of the local crown financial institutions which have government mandates to decarbonise their portfolios. Here it may be appropriate that benchmarks reflect their reduced opportunity set. This includes last year’s adoption of the MSCI Climate Paris Aligned indices by the NZ Super Fund, and the adoption of the MSCI Low Carbon Target indices by the Accident Compensation Corporation and the Government Superannuation Fund.

Instead Russell NZ recommends the ‘Reference Portfolio’ construct which was developed by the Canada Pension Plan Investment Board and has been adopted by New Zealand’s crown financial institutions (CFIs).

“It is a straightforward total portfolio construct that can either be used alongside the composite portfolio benchmark or in isolation to judge the overall impact of active decision-making and provide a better assessment of the real value add for institutional investors. Understanding the results of a portfolio or an investment programme relative to an appropriate, viable alternative, i.e. a different portfolio strategy and/or comparable peers, is a vital element of modern institutional investing.

Tags: Russell Investments