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Selecting a Benchmark for ETF Managed Portfolios

It's time to move beyond the S&P 500 Index. 

Andrew Gogerty, 12/19/2013

Benchmark selection is a main talking point in the ETF managed portfolio universe. The industry's continued growth over the past two years has pushed these strategies closer to the main stage in the managed-account space. As these strategies have graduated to full-blown competition alongside traditional separate-account offerings and managed-account solutions, advisors and platform due diligence teams understandably are asking how to measure whether ETF managed portfolios are earning their keep.

Surprisingly, the industry hasn't collectively decided on proper benchmarks for some of these strategies. Three key factors--all of which stem from the ETF as a primary investment vehicle and technology platform--have caused the current conundrum:

Tactical Flexibility.--ETFs enable these firms to make regular tactical moves between asset classes and market exposures (including cash) in a cost-effective manner. This flexibility makes it difficult to do a holdings-based comparison because the strategy can hold everything and move quickly. (This freedom also can make the strategy more difficult to explain to a client compared with single style-box offerings.)

Comprehensive Offering.--Many global all-asset strategies are designed as a single portfolio solution from a single manager, doing the work that previously may have been spread across several managers in a client's portfolio. Getting comprehensive exposure from a single source doesn't require the long-standing process of picking manager A for stocks, manager B for bonds, and so forth. If the strategy isn't simple, it probably shouldn't have a simple benchmark.

Benchmark Versus Index Confusion.--Since tactical, comprehensive strategies don't have straightforward benchmarks, some advisors and asset managers drop back and punt, simply measuring a strategy's risk and return characteristics against the S&P 500 Index or another broad-based market proxy. These benchmarks may be easy for a client to follow, but they don't measure the investment relative to applicable standards. It's important to distinguish between benchmarking--this action of measurement--and an index that is simply something that serves to guide, point out, or otherwise facilitate reference.

There are few, if any, instances where an advisor should have to ask a manager, "What's your strategy's benchmark?" Benchmark identification should be the output or end result of the discussion and research between the advisor and the asset manager providing the strategy. The benchmark should measure the desired outcome relative to the next-best alternative.

A Pragmatic Plan of Attack
Instead, an advisor should begin by asking, "What is the strategy's purpose in the portfolio?" There isn't a one-size-fits-all benchmark for many ETF managed portfolio strategies. Rather, these strategies are best viewed alongside a benchmark that helps to highlight the answers to two key questions: "What is the strategy's goal?" and "What can it replace in the current portfolio?" This is similar to how one would assess an entire portfolio. When constructing and selecting a benchmark for an ETF managed portfolio, consider these key factors:

Match (and Understand) Use and Purpose.--Whether the advisor outsources the client portfolio to multiple managers (or strategies), or just one comprehensive global all-asset offering, the advisor remains the overall portfolio manager on behalf of the client. Portfolio managers allocate capital, so in these cases, the advisor recommends which strategies to employ and in what weighting. Advisors should start by identifying the use and purpose of the potential strategy. First, determine the strategy's the role in the client's portfolio. Is it a core strategy, a source of alpha, or a niche satellite offering? Or do you aim to comprehensively outsource the entire portfolio? From there, identify what the strategy's return stream will do to the portfolio's current characteristics. For example, will it increase downside risk protection, generate alpha, diversify returns, or improve the Sharpe ratio? (For more on this process, see "Selecting an ETF Managed Portfolio--Part Two: Strategy Selection and Use in a Portfolio.")

Andrew Gogerty is the ETF managed portfolio strategist at Morningstar.

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