Contemporay Issues in Finance

Describe the ‘benchmark problem’. What are implications for active portfolio management?

In portfolio management, the portfolio manager will be asked to maintain or even outperform a benchmark return, which at a minimum would typically be the return generated by the market. When asked to outperform the benchmark, it would seem to imply that the manager would have some greater degree of skill and insight as the performance of their portfolio would typically outperform the market.

This, however, is not always the case as a portfolio manager can outperform the benchmark without having any market timing or stock picking ability. This ability to outperform is due to benchmark inefficiency and a portfolio manager can exploit this inefficiency with sheer luck and without utilizing any particular unique skill.

The ability to outperform the benchmark is monitored by the information ratios; with higher information ratios, implying a higher level of skill in market timing or stock picking. However, an analysis of the information ratios of portfolio managers reveals that over time, the ratios settle to normal levels indicating that the managers are not able to maintain their superior performance. This implies that a positive information ratio is not necessarily an indicator of skill.

It can be asked whether active management can counter the benchmark problem and it should be noted that whilst active managers will beat their benchmarks some of the time, the persistence of these superior returns has been shown to decay fairly rapidly over time. The superior returns can be attributed to the positive momentum of previously selected outperforming stocks rather than a manager's ability to consistently choose new high performance stocks. As the momentum of these stocks slows, the result is that without new investment, the fund will likely have a difficult time staying on top for long.

Additionally fees for fund management, which typically comprise of a management fee...