Lies, Damn Lies, and Benchmarks: An Injunction for Trustees

Abstract

Most institutional investors, such as public pension funds and endowments, report their performance using biased benchmarks. The benchmarks are biased downwardly, meaning their returns tend to be less than a fair return for the market exposures and risk exhibited by the institutions’ portfolios. Significant samples of both fund types exhibit benchmark bias in the range of 1.4 to 1.7 percentage points per year. This bias enables a sizable majority of both types of funds to report outperforming their chosen benchmarks when, in fact, most underperform an appropriate passive-management benchmark by a wide margin. Benchmark bias masks serious agency problems in the management of institutional funds. For example, fund staff and consultants have strong incentives to justify complex, costly, multi-asset-class portfolios, for which they themselves are the benchmarkers. Trustees may feel they have no choice but to accept the benchmarking and reporting by staff and consultants, but this only perpetuates the problem. At the very least, investment trustees should step up and take control of benchmarking and performance reporting. For they are the ones charged with watching the watchmen.