For example a NZ share fund might be compared with the NZX 50 Index, an Australian share fund might be compared with the S&P/ASX 200 Fund and a global share fund is judged against the performance of a global index like those available from MSCI.
Here's what the NZ Super Fund has to say about how they use benchmarks: "The NZ Super Fund uses benchmarks to assess how much of the performance of a specific mandate is attributable to the capability of the manager versus overall performance of the relevant market.
For example, the performance of the Fund's active NZ equities mandates (internal and external) is judged relative to the NZX50 index rather than simply on an absolute basis."
Of course benchmarking performance isn't specific to the world industry - most industries have key performance yardsticks against which to assess efficiency and effectiveness.
But as with any measure of performance benchmarks are subject to abuse and as a fund manager who outperforms a benchmark attracts more investors and thus more fees the less ethical elements in the investment industry are continually looking for easy to beat benchmarks.
I remember taking a fund manager to task back in the 80's for comparing his fund's performance inclusive of dividends with a NZ stock exchange index which excluded dividends.
The Financial Times noted this sort of unethical behaviour too when it quoted a fund manager as saying "the easiest way to look tall is to stand by a short person".
In the USA, UK and latterly NZ, the regulatory authorities are compelling fund managers to include a graph in their reports to unitholders which compares their performance after fees, pre-tax with an appropriate index.
Now this might seem like "mission accomplished" but it still leaves local fund managers considerable wiggle room to "stand by a short person".
The two most common instances of index abuse are committed by fund managers investing in shares and bonds.
Both abstractions of reality involve risk. Recall that higher risk investments outperform so if you are a fund manager ideally you want to pick a less risky index with lower returns and you will likely look good even if your fees are high.
No surprises that that's exactly what they do.
Some fund managers have investment portfolios which are overweight higher risk, small company shares but conveniently benchmark themselves against the broad market index when the midcap or small company index is more appropriate, and harder to beat.
The other area where fund managers use inappropriate indices to look tall is in the bond sector where they sometimes compare themselves to low risk government bonds despite their own portfolios being loaded with corporate and unrated debt.
However all is not lost.
It is very encouraging to see that the local financial police realise the significance of benchmarks and their potential for abuse.
According to an FMA spokesperson "the purpose of the market performance index requirement in the regulations is to help compare the performance and volatility of the fund with a particular market."
The other less obvious but very significant piece of information conveyed by comparison with a benchmark is that it highlights the impact of a fund's fees.
Specifically, over the longer term the higher a funds' fees the more it could be expected to underperform a benchmark.
In a recent publication the UK's FCA said "our evidence suggests that actively managed funds do not outperform their benchmark after costs" and the FCA estimated that because of fees a low-cost passive fund could earn 44 per cent more over a twenty year term.
Contrast this view on costs from the FCA, an independent government department charged with protecting consumers, with a recent submission by the NZ Bankers Association to the MBIE on fees: "fees are one element of the overall retirement investment. In an actively managed portfolio, higher fees are appropriate. All fees should be considered in light of the total return".
The Bankers Association then went on to express its grave fears that the focus on fees "could drive a culture where KiwiSaver members chased low fees at the expense of optimal savings growth."
It's not awfully clear what would be wrong with this sort of strategy!
If you haven't already noticed it's pretty obvious that benchmarks are a huge threat to the profitability of the investment industry.
Consequently some people would like to have us believe that benchmarks are too complicated or not relevant to retail investors.
They can obviously be problematic for fund managers and financial advisors with high fees. Just a few weeks ago on the financial advisor website, GoodReturns, a number of financial advisors went on record as saying that as clients didn't know what benchmarks to use that they shouldn't use them and should instead focus on "goals".
As the NZ Super Fund pointed out earlier benchmarks allow us to assess the performance of the fund manager.
Professional investors around the world rely on benchmarks and as we noted benchmarks are critical to assess the efficiency and effectiveness of any industry. In contrast the thrust of the argument here seems to be "if you can't beat the benchmark then don't mention it to clients". Putting clients' interest first - I don't think so.
The practical application for Mum and Dad of comparing your fund manager with a benchmark is to assess performance in the medium to long term.
If your fund is deviating from the index - above or below it might be useful to understand why. Is it due to the fund manager genuinely adding value, high fees, bad luck or is the benchmark inappropriate.
Once you get a feel for any deviation you can assess performance and remember in the long run the most likely reason for underperformance will be high fees. It is important not to make these decisions quickly and fund manager styles can underperform in the short term but turn out well in the long term.
If you are unhappy with your fund manager due to underperformance and/or high fees you can always enlist the services of a low cost passive manager and thereby track the benchmark closely.
Brent Sheather is an Authorised Financial Adviser. A disclosure statement is available upon request. Brent Sheather may have an interest in the companies discussed.
