Performance benchmarks for institutional investors 109
The US has similar external asset-class and peer-group bench-
marks as the UK. Other countries tend to use ﬁxed or bond-based
In conclusion, we ﬁnd that benchmarks are important, but so are
fee structures. They can either provide the right incentives for fund
managers or they can seriously distort their investment behaviour.
The issue of performance benchmarks for institutional investors has gen-
erated a great deal of controversy recently. Are they set too low, making
them very easy to beat? Are they set too high, making them hard to beat
unless fund managers take on excessive risks? Is the frequency of assess-
ment against the benchmark (typically on a quarterly basis) appropriate for
long-term investors? Do they introduce unintended (and undesired) incentives,
such as the incentive for fund managers to herd together or to avoid hold-
ing securities (such as those of micro-cap, small-cap, unquoted or start-up
companies) that are not included in the benchmark? How, if at all, should
performance against the benchmark inﬂuence the fund manager’s compensa-
tion. How should the fund’s liabilities be taken into account when assessing
the fund’s performance. This chapter examines and assesses the benchmarks
that are currently used by institutional investors in the UK. It also looks at
possible alternatives to these benchmarks and brieﬂy reviews what happens
in other countries.
5.2 WHAT BENCHMARKS ARE CURRENTLY USED
BY INSTITUTIONAL INVESTORS?
Performance benchmarks in the UK have been around since the early 1970s.
They are an essential part of the investment strategy of any institutional
investor and help both to deﬁne client/trustee expectations and to set targets
for the fund manager. Benchmarks can be set in relation to liabilities and can
therefore change if the liabilities change, say, as a result of increasing maturity.
Benchmarks might also be inﬂuenced by regulations (e.g. a Minimum Fund-
(MFR)), accounting standards (e.g. Financial Reporting
(FRS17)), or client/trustee preferences (e.g. trustees might prefer
Introduced in the UK by the 1995 Pensions Act and operating from 1997, but it was announced
in the March 2001 Budget that it would be scrapped.
Issued by the Accounting Standards Board in November 2000 and coming fully into force in June
110 Performance Measurement in Finance
to minimize the volatility of employer contributions into a pension plan than
minimize the average level of employer contributions, given that, in ﬁnal
salary plans, the pension is funded on a balance of cost basis).
The benchmark, appropriately set, has important implications for how the
actions of the fund manager are interpreted. An appropriate benchmark rec-
ognizes formally that the strategic asset allocation or SAA (i.e. the long-run
division of the portfolio between the major categories of investment assets,
such as equities, bonds and property) is a risk decision relative to the liabili-
ties, rather than an expected return decision. In other words, the SAA, properly
interpreted, is not an investment decision at all: instead it is determined largely
by reference to the maturity structure of the anticipated liability cash ﬂows. In
contrast, the stock selection and market timing (i.e. tactical asset allocation)
decisions are investment decisions and it is the fund manager’s performance
in these two categories that should be judged against the benchmark provided
by the SAA.
5.2.1 Single-index benchmarks and peer-group benchmarks
The two main types of benchmarks used in the UK are external asset-class
benchmarks and peer-group benchmarks. These benchmarks are used by both
‘gross funds’ (i.e. those without explicit liabilities) and ‘net funds’ (i.e. those,
such as pension funds, with explicit liabilities). When external performance
measurement began in the early 1970s, most pension funds selected cus-
tomized benchmarks (which involved tailoring the weights of the external
benchmarks to the speciﬁc requirements of the fund). Shortly after, curiosity
about how other funds were performing led to the introduction of peer-group
benchmarks. More recently, following the recognition that the objectives of
different pension funds differ widely, there has been a return to customized
The WM Company,
for example, uses the following set of external bench-
marks to assess the performance of the pension funds in its stable:
• UK equities: FTA All Share Index.
• International equities: FT/Standard & Poor World (excluding UK) Index.
• North American equities: FT/Standard & Poor North America Index.
• European equities: FT/Standard & Poor Europe (excluding UK) Index.
• Japanese equities: FT/Standard & Poor Japan Index.
• Asia – Paciﬁc equities: FT/Standard & Poor Asia – Paciﬁc (excluding
The WM Company is one of the two key performance measurement services in the UK, the other
is CAPS (Combined Actuarial Performance Services).