CutterAdvantEdge

Issue 53, October 2007

Indices and Benchmarks - We Can't Live Without Them, So We Better Figure Out How to Live With Them

Indices: are they up or down?
Benchmarks: are we ahead or behind?

Asset managers measure their success or failure based on their performance relative to indices and benchmarks. Although they have been around for decades, we have recently seen a rapid growth in the number of indices being published, and the complexity of benchmarks being tracked.

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It is readily apparent that new investment strategies are being developed and implemented at an ever increasing rate - the race for alpha has not slowed. New structured products seem to come to market almost daily. Derivatives have become a management challenge for even the most conservative asset managers. Hedge funds, private equity, emerging markets, exchange traded funds - the list of investment vehicles (and their associated alphabet soup of acronyms) seems endless.

If there is a constant in this dynamic and volatile environment, it is the questions: Are these complex strategies worth it? How well do these strategies perform? Is there sufficient return to justify the increased risk and operational complexity? While the answers may not always be obvious, one of the constant threads behind each of them is the need to measure performance - and performance is always measured against a benchmark.

John Clark, Principal of Cutter ConsultingT observes "as our clients' investment strategies become more complex, the challenge of identifying and calculating the most appropriate benchmark also grows. For example, as firms move beyond total return driven strategies to liability driven investing, the ability to develop accurate benchmarks that combine liability matching with total return poses an even greater challenge." The index providers are scrambling to meet these demands.

Is the data I want/need available?

Asset management firms are struggling to identify the most appropriate benchmark against which to measure the performance of their latest investment product and strategy. Sometimes the appropriate benchmark is obvious (I want to increase my exposure to government bonds in Japan, what is an appropriate benchmark?), and sometimes it is not (I want to increase my exposure to private equity, what is an appropriate benchmark?).

Once asset management firms have identified an appropriate benchmark, they are faced with the challenge of tracking it. They are faced with a number of choices:

Does one of the index data providers already provide an appropriate index? If so, can I get it through my redistributor?
Will one of the index data providers calculate a custom index to support my investment strategy? If so, will they make it available to me through my redistributor?
Do I have, or can I get, the data to build the benchmark myself? If so, what construction methodology should I use? How will I verify the accuracy and integrity of my calculations?
Are there any other options available to me?

Index data providers and redistributors are devoting tremendous resources to these issues:

Virtually all of the major index providers are publishing new global index families, revising and/or extending existing index families and individual indices, and developing custom indices to meet individual client demands
Redistributors are adding new index families and indices to their product offerings as driven by client demand

...in the News...

IDFC Partners FTSE in Creation of New India Infrastructure Index Series

MSCI Barra Launches Global Family of Islamic Indices

Russell Launches Global Equity Indexes

S&P Expands Global Thematic Index Series

Okay, I can get the data I need - what do I do with it?

Index specific data faces the same challenges as the broader category of reference data:

How do I insure it is accurate? How do I enrich it if necessary?
Where do I store it?
How do I distribute it?
Do I have (or can I put in place) license agreements that allow me to meet my business requirements?

Pie graph - Firms reporting ability to accept benchmark data at any level

There are almost as many approaches to answering these questions as there are asset management firms. Manual processes for gathering and entering index data coexist with automated feeds from vendors. Sometimes index data is imported directly into individual applications, and sometimes into a shared data store. Benchmarks are often calculated in a single application and shared as needed, while in other cases the same benchmark may be calculated multiple times. When indices and their constituents are considered, data volume is a huge challenge to asset managers. Data cleansing, validation and enrichment take on a dimension of practical necessity, but many firms wonder if this approach is truly "good enough".

"... we have 12,000 securities in our asset file that represent positions in our portfolios, but the indices we track include over 100,000 securities ..."

- leading global asset manager

Both index providers and redistributors recognize that data volume and consistency is a major challenge for their clients, but their ability to offer practical solutions is limited:

An increased emphasis on data completeness and data quality is part of the marketing message of every service provider
Although virtually all redistributors only deliver "official" index data, most of them take on a role of advocacy with the data providers, validating data and questioning perceived anomalies with individual index providers to ease the data cleansing challenge for their clients
Redistributors are actively trying to ease the internal processing burden of asset management firms by offering common formatting and single sourcing for data from multiple index providers
When permitted by the index provider, many redistributors are offering data and sometimes calculations that are not available directly from the index provider

This is a big problem - what can I do?

Index and benchmark data management is a critical challenge to asset management firms. Whether addressed within the context of reference data management or whether it is or becomes a project on its own, it is ultimately critical to the firm. The long term success of the firm is very often determined by the answer to the questions "are we ahead of or behind our benchmarks, and why?" Timely, accurate responses to these questions often make the difference between success and failure.

The challenges of identifying, obtaining and managing index data and constructing benchmarks is growing, and shows no signs of getting any easier. Manual and/or decentralized data management practices and processes are not providing the flexibility and responsiveness demanded by the investment professionals and client service teams at asset management firms.

At the Technology Council™ meetings in London on November 15 and New York on November 28, CutterResearch will present a detailed review of index data providers and member challenges and practices around maintaining and using indices and benchmarks.

Cutter Associates will provide a detailed update on Order Management and Compliance Systems on October 11 and 12.