Most would agree that benchmarks are fundamental to fair representation as they provide a point of reference for both performance and risk. As well, they serve as a focal point for the relationship between investor and manager as they assist in defining expectations (i.e. what is considered a success and failure). Given their importance, it should come as no surprise that the decision to change a benchmark requires rigid disclosures. The GIPS standards lay these out, and they were recently reinforced with the October publication of the Guidance Statement on Benchmarks. This article examines the two types of benchmarks changes and the requirements for their adoption.
As a means of providing background, GIPS states that a benchmark’s appropriateness is linked to its reflectiveness of three benchmark characteristics. These are: (1) Investment Mandate, (2) Objective, or (3) Strategy. Sometimes a manager may develop the conviction that a currently utilized benchmark is no longer appropriate. For instance, previously firm assets were at a level that made acquiring small/mid-cap securities possible. However, this is no longer the case. Strong growth in AUM over years now requires the firm to acquire more liquid, large-cap securities so as to optimize client trade allocations. In terms of disclosure, firms must provide the date that the composite benchmark changed, along with its description and the reason for the change. This must be done for as long as returns for the old benchmark are included in the compliant presentation, which GIPS requires to be ten years if available. In this case, the manager may view as prudent switching from the Russell Mid-Cap U.S. Stock Index to the Russell 3000 Index, the latter representing an All-Cap U.S. Stock Index. Important to note, benchmark changes can take two forms:
- Prospective – The composite benchmark is changed from one benchmark to another at a given point in time, perhaps as a strategy changes.
- Retroactive – The composite benchmark is changed from one to another for all periods since inception.
The Russell 3000 Index is a capitalization-weighted stock market index, maintained by FTSE Russell that seeks to be a benchmark of the entire U.S stock market. In most cases, changes to composite benchmarks are made prospectively. Such is the case in the example described above where the manager utilized the Russell Midcap Index up until December 31, 2016.
The Guideline Statement makes a great point that because benchmarks are continually evolving, if the firm finds that a new benchmark is a better representation of an investment strategy, the firm may consider changing the benchmark retroactively. The firm must disclose that the benchmark has been changed retroactively. In addition, firms are encouraged to continue to present the old benchmark. If the firm changed a benchmark retroactively, it is important that the disclosure of the change remain in the compliant presentation for as long as it is meaningful as per the firm’s policy and the disclosure can be removed once it is no longer meaningful. The firm must create a policy for determining the length of time that retroactive benchmark changes are disclosed, and apply that policy consistently.
Firms must not make changes to the benchmark primarily intended to make performance look better by lowering the benchmark return. Moreover, the processes in determining and executing the change in benchmark cannot be based on haphazard decision-making. Rather, in accordance with GIPS, they must be maintained within the firm’s policies and procedures. Finally, it is recommended that the documentation also include all review and approval processes.
Exposure Draft of GIPS® – Guidance Statement on Benchmarks. www.gipsstandards.org, © 2017 CFA Institute. All rights reserved.
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