Why Funds Use Index Benchmarks Instead of Absolute Returns

# What is the motivation for index benchmark?


# What is the motivation for index benchmark?












I know that many funds have local index (i.e., SPX in US) as their benchmark. Why are investors interested in such kind of returns instead of absolute returns. From the first glance I'd think one would only care to make the maximum amount of money rather than be positive in relation to some index. I often hear how people talk about "if everything falls 50%, but your allocation falls 48%, that's like +2%". At the same time I can't understand why wouldn't you then invest in absolute return fund which might actually make money in this period, and in such case could be considered over +50% return if it is so important to outperform index...

So, the question is: why funds with index benchmarks exist and who is interested in such, versus absolute return.

## Answer by Matt Wolf (score 3, accepted)

https://quant.stackexchange.com/a/11284

Summary Answer: Those are interested to benchmark against indexes who sell such index products (pricing data, trade marks, rights to use and publish), and of course portfolio managers because they look generally much better when indexed against indexes than when being assessed through risk-adjusted returns. The general public is sadly just too uninformed to complain much.

Cynical and Winding Answer:

For the precisely same reason than airlines asking you to fasten your seat belts. Its not that a seat belt would make the slightest of differences when a plane crashes, but it makes people feel safe and cared, you know, that warm fuzzy feeling, when during 2008 your investment advisor called you up and cheerfully let you know that his stock picks performed 10% better than the overall market. Unfortunately you lost 40% of your market value.

I take a very critical approach to most motivations by market practitioners in the financial arena. What I have learned early on is that 1-2% are truly smart and outstanding alpha generators, another 8-9% perform vital and important support functions to sustain the 1-2% alpha generators, and all the rest in this industry are like pilot fish around sharks (defined as parasites and those feasting on leftovers). There is a whole indexing service industry subculture where such sales men arrive at your office to tout their latest wares in custom tailored suits, sun-tanned faces, wrist watches twice the size of their arms. The first time you see it you will be amazed, then surprised, and in the end you will run out of the meeting room screaming because you realized that a lot of your retirement and investment portfolios is eaten up by such people. They wine and dine your portfolio managers and he insists along all his colleagues during the daily investment meetings that portfolios must be benchmarked against indexes they themselves choose. A portfolio manager's, or better, fund sales person's worst nightmare is the term "risk adjusted return metrics".

Am I being cynical or bitter? Cynical yes, bitter no, but as soon as you witness just enough of the shenanigans that most in this industry are engaged in you gotta start laughing and smiling a lot more which is often taken as cynicism.

## Answer by Onyxx (score 3)

https://quant.stackexchange.com/a/11285

The first reason is the answer to this question :

should I bother invest in your fund and not simply invest in the S&P500 etf ?

The second is :

Are you a fraud ?

If someone claims to use a long only strategy with stocks from the S&P500, you expect his fund returns to be correlated to the S&P500 to some extent. If it is not the case => fraud.

## Answer by user2763361 (score 3)

https://quant.stackexchange.com/a/11291

There are a few things:

Non-cynical:

- Active absolute return managers tend to underperform passive benchmarks after fees. So if you can get a manager that can outperform a passive benchmark (perhaps who has a mostly passive strategy with some active tilts), then you are doing well.

- Your scenario of a portfolio dropping 48% is not realistic. Most asset allocation guys will diversify with safe haven assets that are negatively correlated with typical risky assets during market turmoil. This could include gold, USD, CHF, US bonds, a negative beta manager, or some financial engineering products. Thus your expectation in a crisis might be better than only going to absolute return under certain allocations (and it wouldn't be - 48%). The key is to think on the allocation level instead of the level you were thinking of which is the manager level.

Cynical:

- The boards of pension funds and endowments will fire you if you do not make some acceptable quartile of performance among peers. Even if you are max $E[R(t)]$ and min $\sigma(R(t))$ by investing in absolute return in a statistical population sense, it is completely irrelevant to career risk. By choosing absolute return you will be maximising the variance of your returns around your peers (peer-relative tracking error), thus maximising career risk. If it comes to a trade off between career risk and the lower utility of your clients, the manager of the endowment and its investment consultant will choose to lower the utility of their clients (in my experience). (Liquidity providers are demonised, but who are the real cancers here?)

## Answer by Tom Au (score 0)

https://quant.stackexchange.com/a/11293

It's called "keeping up with the Jones." A lot of people are less worried about how much money they will make, than whether they keep up with (and therefore get to live and retire in the same style as) their friends, coworkers, or some other reference group. That applies to most fund trustees. Most of them like to compare notes with their peers on the golf course, and their primary concern is NOT to be "embarrassed."

## Answer by user3264325 (score 0)

https://quant.stackexchange.com/a/11513

Why do index benchmarks exist?

Benchmarks are needed to quantify alpha. It's a relative measure after all

Why invest in slightly more passive index relative funds over absolute return?

Index tracking funds are popular because of a wide spread belief in market efficiency