Measure performance with a custom index
LAST week, this column discussed the Bursa Malaysia indices and their performance over the past three years. As we know, investing today is more about choosing the right market sectors or themes and, with that, the individual stocks that will make up a stock investment portfolio.
For asset managers, a tailored product offering is essential as they attempt to respond to investors’ ever-changing appetite for risk and returns by introducing more sophisticated products.
The question is how would investors assess the performance of their fund managers, especially if the right measurement tool is not being used?
For example, in one of the asset management companies, one of the funds is a small cap fund which is benchmarked against the FTSE Bursa Malaysia Small Cap Index (FBM SCI).
Based on its investment policy, the fund is permitted to invest in companies with a market capitalization of up to RM3 billion at the point of purchase, and up to 20% of the fund size is also permitted to invest in companies with a market capitalization greater than RM3bil.
While the mandate specifies the objective of the fund and the investment parameters, one wonders if a correct benchmark is chosen.
Based on its fund fact sheet in December 2021, the fund performed very well for the year with a gain of nearly 11% versus the benchmark of just 1.25%, an outperformance of more by 9.7 percentage points (pps).
In fact, over the three-year and five-year period and even since its inception, this fund had outperformed the benchmark by 25.5pp, 41.7pp and 180.7pp, respectively.
For the uninviting, the fund has performed extremely well and should be an attraction for mainstream investors, but is it?
Logically, a fund manager’s performance should more or less mirror that of the benchmark against which their performance is measured, in the hope that they will always beat the index, perhaps slightly but certainly not. of a mile.
The fund’s fact sheet revealed that among its 10 largest holdings, there is even one company that has a market capitalization of over RM17bil! Admittedly, it is not a small cap company as it is a member of FBM KLCI.
Of the top 10 holdings held by the fund, two are in the top 100 constituents of the FBM index and four others have a market capitalization above RM1 billion.
Although the mandate allows the fund manager to invest in these companies, calling the fund a small cap fund seems rather misleading because the market perception of what a small cap is is different from how regulators define them. .
Although there is no clear definition of what constitutes a small cap company, Bursa Malaysia and the Securities Commission’s definition of other indices may provide a better idea.
As explained in the Malaysian Corporate Governance Code 2021, large companies are defined as those that are either constituents of the FBM Top 100 Index or companies with a market capitalization exceeding RM2bil.
For companies that have a market capitalization of RM200mil to RM2bil under the FBM Emas Index, these are also classified under the FBM Mid Cap Index (FBM MCI).
For the FBM SCI, the rule of thumb defines index companies as those in the top 98% of Bursa Malaysia’s main market, but excludes companies in the FBM Top 100 Index.
At the end of December 2021, FBM MCI had a total of 216 constituents while FBM SCI had 214 constituents. According to the definition of the basic rule, it is likely that most of the companies that are part of the FBM SCI are also constituents of the FBM MCI.
To return to the example given, by definition, small capitalization companies are the 216 companies of SCI FBM. However, the fund management company has added flexibility to invest outside the set parameters, but this cannot exceed 20% of the fund size at the time of purchase.
With this, can the fund manager claim that he did a good job? Is the fund calibration correct when the actual performance greatly exceeds the underlying index?
The above also explains the market’s perception of what a small cap fund is and how in reality it is very different because, based on the definition of the index, small cap companies are not so small after all and some of them are even big companies with a market capitalization over RM2bil.
The general public, too, although focusing on performance, and perhaps to some extent on the name of the fund, should read the prospectus of a newly launched fund in more detail to understand the mandate and the settings and not be misled by the name of a fund.
Custom Index Overview
We’ve all heard of how fund managers define their performance against a particular index. With this, we define a good or bad fund manager based on whether they are able to deliver that superior outperformance or have underperformed the benchmark.
In theory, as we see in funds that track a particular exchange-traded fund, a fund manager should be able to “perform the market” because they use a benchmark index to build their portfolio.
Investors are “willing to pay” an outperformance fee when a fund manager is able to beat the market by picking winners within the benchmark or, in some cases, they deviate (such as the permits given mandate) to provide investors with extra returns or alpha.
A custom index allows fund managers to build custom portfolios, based on a particular fund’s objective or based on defined parameters.
This is because a custom index is more about choosing the right stocks in a portfolio and then a benchmark is created to reflect the underlying stocks in the portfolio. It is not compared to an established index but is created for each individual portfolio.
The question of the replication of an index does not arise since a new index is created immediately after the definition of the actions that make up the mandate. In this way, the fund manager has clear parameters, he does not have the possibility of deviating from the mandate and his performance measurement will be more precise.
The only way for the fund manager to outperform the benchmark is to overweight the stocks that are expected to perform well and underweight the other stocks that make up the custom index.
Should the benchmark be regulated?
While regulators, in approving a new fund, are preoccupied with compliance and risk management issues, little attention is paid to how the performance of a particular fund will be measured and with that the discipline to ensuring that investors buying these products have the right exposure and not masked by other unrelated underlying assets.
Regulators should redefine how benchmarking is done, because in today’s technology tools, creating a custom index isn’t too troublesome. Any fund mandated to invest in stocks that do not reflect a particular chosen benchmark should be required to establish a custom index.
This way, the actual performance of the fund manager can be truly assessed and not distorted due to the use of the wrong benchmark.
Pankaj C. Kumar is a longtime investment analyst. The opinions expressed here are those of the author.