Introduction
In the world of finance, benchmarks serve as crucial yardsticks for evaluating portfolio performance and guiding investment decisions. However, the misuse of benchmarks has become a prevalent issue, leading to misaligned expectations and potential mis-selling of investment products by advisors and fund managers. In this article, we explore how advisors and fund managers have misused benchmarks, particularly in the context of portfolio management strategies such as investing in micro to small-cap companies or momentum stocks.
The Pitfall of Misaligned Benchmarks
Benchmarking with Inappropriate Indices
One common pitfall is benchmarking portfolios with inappropriate indices. For example, many Portfolio Management Services (PMS) managers invest in micro to small-cap companies, which inherently carry higher risk and potential for higher returns. However, some of these managers benchmark their portfolios with indices like the Nifty 50, which comprises the top 50 stocks by market capitalization. This misalignment can mislead investors into expecting returns that are not reflective of the portfolio's actual risk profile.
Misleading Performance Expectations
Benchmarking with broad market indices like the Nifty can create misleading performance expectations. While these indices provide a broad overview of the market, they may not accurately represent the performance of portfolios focused on specific segments or investment strategies. Consequently, investors may be disappointed if their portfolios underperform relative to the benchmark, despite achieving satisfactory returns within their designated investment universe.
Momentum Portfolio Managers and Benchmarking
Benchmarking with Broader Market Indices
Another scenario involves momentum portfolio managers benchmarking their portfolios with broader market indices instead of using benchmarks that align with their investment strategy. Momentum investing involves buying stocks that have exhibited strong price performance in the past, with the expectation that this trend will continue in the future. However, some managers benchmark their momentum portfolios with broader market indices, which may not capture the specific momentum factor
Misleading Performance Assessment
Benchmarking momentum portfolios with broader market indices can distort performance assessment. Since most momentum strategies focus on short-term price trends in smaller companies with probably lesser liquidity, benchmarking with broader market indices that include stocks with different characteristics and performance profiles may not accurately reflect the portfolio's performance relative to its intended investment strategy.
As a result, investors may struggle to assess the effectiveness of the momentum strategy and make informed investment decisions.