Have It Your Way

October 01, 2002


Way back in the early 1970s, just as passive & quantitative fund management techniques were coming to the fore, an American hamburger chain came out with a jingle which could serve today as one of the global investment industry's theme songs:

'Hold the pickles,
'Hold the lettuce,
'Special orders don't upset us…
'Have it your way!'

In the investment industry, 'your way' of course has meant assembling and maintaining a portfolio customized to suit an asset owner's requirements. Multi-asset class portfolios such as those of institutional investors often have customized asset class allocation targets, where composite performance benchmarks for the portfolio as a whole are synthesized from custom weights being applied to the results for a benchmark from each asset class, or from composites of peer group performance.

The creation and use of custom benchmarks has long roots in equity investing in North America and Europe, where foundation, endowment and faith-based investing have often excluded securities of certain types of businesses (e.g., weapons, tobacco and alcohol) and even companies doing business in entire countries (e.g., South Africa under apartheid and Myanmar today).

As international equities became significant in portfolios during the early 1980s, new reasons to seek customized equities benchmarks arose. Japan's stock market boom in the 1980s led it to reach a very high weight in leading capitalization-weighted benchmarks, weighting levels that many funds consciously rejected for their portfolios. By the late 1980s, 'Japan Lite' (where Japan's weight in a standard benchmark is reduced, typically halfweight) was a commonly used strategy reflected in custom benchmarks. In this and other cases, alternative weighting schemes for asset allocation purposes-such as weighting country exposures by relative size of Gross Domestic Product or by some other measure such as relative stock market liquidity- have been used to constrain country exposures while retaining a disciplined investment approach. Many asset owners such as pension plans also have views on their preferred level of exposure to emerging stock markets, for example, and set target allocations that differ from the emerging markets' weights in standard global equity benchmarks.

The variance of a custom portfolio's asset allocations from those of the standard benchmarks however, gives rise to problems of performance assessment, especially as it relates to measurement of a fund manager's portfolio skills. It makes little sense to compare the results of an emerging markets fund whose investment policy, for instance, forbids Korean stocks, with the results for a typical Emerging Markets Index in which Korea may have a 20% weighting. Whether the mandate involved is active or passive, the need to compare 'like for like' in such circumstances requires truly customized benchmarks.

What Is A Custom Index?

In its most simple form, a custom index is a user-specified version of a standard commonly accepted index for some investment category. The Journal of Indexes' own stats section lists an impressive number of what we would call standard benchmarks.

Typically, simple customization excludes some stocks normally found in the standard index. The customization can increase in complexity, just as any investment strategy can have more overlays and 'tweaks' added in. At the higher levels of portfolio complexity, an index may have to be built from scratch.

Note that the asset allocation benchmarking function commonly attributed to standard indexes is specifically not a function of a customized benchmark. The party commissioning the custom index, usually a fund manager acting on behalf of a mutual fund, commingled account or segregated account, typically defines the asset mix and/or the calculation methodology.

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