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When Complicated Funds' Benchmarks Don't Measure Up
Article published on March 25, 2014 on BoardIQ, a Financial Times Service.
By Whitney Curry Wimbish
The way liquid alternative mutual funds are monitored and managed is putting some boards in an awkward position, directors and others say. They say this type of fund presents a confusing and potentially troubling situation when the portfolio manager wants to change its benchmark.
The setup for the situation is this: a liquid alternative mutual fund aiming to manage volatility projects a certain long-term return. The fund is measured against a broad-based index, as required, as well as a custom benchmark of various indexes. None of the indexes, however, reflect how the fund is actually managed. So the portfolio manager says the board should look at returns over “market cycles,” not on an annual basis.
Now the portfolio manager wants to change the benchmark. But because the benchmark does not match well with the fund’s actual investment strategy, and because “market periods” are chunks of time selected by management that can differ from peers, it’s difficult to tell if doing so is truly necessary.
“How does the board know if the benchmark is bad or if the management is bad?” one longtime director says. “It leaves board members in the awkward position of seeing whether the adviser and the subadviser are delivering on the benchmark.”
Directors who face this situation oversee highly engineered mutual funds – ones that do not fall neatly into a Morningstar category and don’t truly resemble the “appropriate broad-based securities market index” required to be listed on Form N-1A. On that form, mutual funds must disclose the returns of such a benchmark next to their own one-, five-, and 10-year returns for calendar-year periods. A fund may also include information for one or more other indexes and a narrative explanation about that data.
“A fund is encouraged to compare its performance not only to the required broad-based index, but also to other more narrowly based indexes that reflect the market sectors in which the fund invests. A fund also may compare its performance to an additional broad-based index or to a non-securities index…so long as the comparison is not misleading,” the form says.
Form N-1A also indicates that if a fund wants to change a benchmark, it must explain the reasons for the change “and compare the fund’s annual change in the value of an investment in the hypothetical account with the new and former indexes.”
Directors overseeing quantitative funds and others within the massive group of products labeled “alternative” also face greater difficulty in determining an appropriate benchmark and when to change it.
When confronted with this situation, directors should first learn what caused the original benchmark to no longer be appropriate, board and risk experts say. Valid reasons include that managers made dramatic changes to the fund’s investment strategy or methods they use to achieve returns changed fundamentally. Directors should ask for specific evidence that the benchmark must be changed, such as whether portfolio managers added asset classes they previously didn’t use.
“My rule of thumb is that you want a rationalization from the adviser about why they’re changing it. You want assurance that the benchmark is not going to change again two years from now,” says Jeff Keil, a principal at Keil Fiduciary Strategies.
Directors asked to approve a new benchmark should agree to do so with caution, fund board experts say, trying especially to avoid a situation in which a change is being made solely for cosmetic purposes. Directors should next aim to understand the adviser’s intention, says Stephen Lewis, independent director and former independent chairman of the Columbia Funds.
“The cynical way of putting it is, ‘Are you trying to game the system on me? Or is there a better reason?’” he says. “What one’s trying to do is pick a benchmark that’s reasonable to the investment objective and how you’re managing the funds. What has complicated that is that we have these multi-asset classes and increasing number of absolute return funds and controlled volatility mutual funds, and all of those tend to use blended benchmarks.”
Marc Odo, research director at Informa Investment Solutions, suggests conducting rigorous statistical analysis on a proposed new benchmark that could include how closely the performance is tracked, measurement of deviations and a description of the factors that caused benchmark and fund performance to diverge.
“If I was in the role of a board member and someone came to me with a proposed different benchmark, I would do some extensive back-testing. I’m willing to listen to what you’re proposing, but let’s see with the benchmark and see, did you ever underperform? On a month-to-month basis? If you’re outperforming either the old one or the new one, well, why? Break it down and help me understand,” Odo says. A major red flag is if the fund consistently outperforms against the new benchmark, he adds.
“I would have more comfort as an independent objective observer if that manager did underperform at certain points in time,” Odo says. “You would expect that sometimes you would lose. The best guys out there, they might outperform the benchmark 60%, 65% of the month. That’s considered pretty good.”
The timing of a request to change benchmarks is another consideration, as is the clarity of the proposed new benchmark, he says. If a portfolio manager wants to change benchmarks after two years of underperformance but talked about how great the performance was against the same target before then, that might be cause for concern. Another problem: if management proposes a benchmark that’s “so obscure and weird and confusing to measure and track” that the board doesn’t understand how it works or how it’s calculated.
Some independent directors say one way to gain comfort that a new benchmark is appropriate is by running the old and new benchmarks simultaneously for a year and then examining the results to see if returns reflect the new standard or simply look better.
“You can’t do it from a disclosure standpoint, you can’t have draft filings to test-drive it in public as far as the SEC is concerned, but at the same time there’s no reason a board couldn’t look at the data and say, ‘We want to see how the benchmark lines up to new data and not necessarily approve it until we see the data,’” Keil says.
Another method to double-check a new benchmark is to ask the adviser what benchmarks similar funds use, some say.
“I hate to say there’s safety in numbers, but at the same time if a lot of other funds appear to have the same strategy and are using a benchmark that’s about the same, that should give the board some comfort,” Keil says.
The longtime director says the subject reflects an ongoing issue boards face as the industry continues to build new and complex fund strategies: that regulation never evolves as rapidly as products are developed, requiring, in this case, that funds be measured against irrelevant yardsticks.
“Managers are wrestling with this, along with the board,” he says. “How do we monitor and manage the fund? The custom benchmark may not be truly effective for how the mutual fund is run.”
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