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Market cap-weighted benchmarks rose to prominence in the decades following the 1950s, when the concept of market ‘beta’ (representing the ‘fully diversified market portfolio’) was developed as part of modern portfolio theory. Benchmarks are now the common proxy for beta. Originally, these benchmarks were used as a guide to help measure a manager’s performance. However, over time, market participants became fixated with analysing every difference between a portfolio and its benchmark, potentially tying investors closer to them and away from their core objectives.
With the rise of benchmark-aware investing, either explicitly (through passive mandates) or implicitly (via ‘closet’ indexing active portfolios) much of the industry has appeared to lose sight of this income-oriented objective, focusing instead on price moves in a market where the instruments redeem at par.
In our view in the credit markets, this obsession with benchmarks raises four key problems: indices are structurally-biased towards the most indebted issuers, market weights can lead to concentration risks, passive funds are prone to forced selling and ‘closet’ indexing can tie active funds to flawed benchmarks.
In our view, being more benchmark-agnostic, through looking for the most compelling credit opportunities, maximises the potential to capture beta and alpha more efficiently. In turn, we believe flexible strategies can help investors exploit the artificial barriers created by benchmarks.”
Gautam Khanna and James DiChiaro, senior portfolio managers. Insight Investment – a BNY Mellon Company
Source: Portfolio Selection, Harry Markowitz, The Journal of Finance, 1952. 3 Bloomberg, Bank of America Merrill Lynch, Insight, as at June 2018