Benchmark-oriented active managers will fall behind.

That’s what Yariv Itah, managing partner at Casey Quirk, argued at an Alternative Investment Management Association event in Toronto on Wednesday.

A paper he co-wrote, Life After Benchmarks, says clients will soon care more about outcomes, such as specific cash-flow needs, than outperforming a benchmark.

But “to get away from the benchmark, you need a lot of courage,” says Jean-Luc Gravel, executive vice-president of global equity markets at Caisse de dépôt et placement du Québec. That’s particularly the case in Canada, where we have fewer names to choose from.

Even though clients will compare your performance to the benchmark over the long term, it can be dangerous to try beating it over the short term. For instance, when Nortel comprised 35% of the TSE 300 (now the S&P/TSX Composite Index), many managers Gravel spoke to knew it was overpriced. But they refused to sell, because they’d lose their jobs if clients didn’t see the stock in the portfolio.

Gravel says the Caisse has moved away from benchmark-oriented investing globally. “You don’t want to be down 48% even if the benchmark is down 50%,” he says. “In terms of risk-adjusted returns, it’s a better approach.”

Success without benchmarks
Managers may feel lost if they can’t compare their performance to the S&P 500 or S&P/TSX 60. The solution, says Gravel, is to create your own comparisons.

His team does 10-year forecasts to determine expected returns for their chosen allocations – for equities, he’s aiming for 7.5%, but with less risk than a typical manager. Then, they tell clients, so managers are kept accountable.

Ray Carroll, CIO of Breton Hill Capital, agrees that setting expectations will calm clients clamouring for comparisons. At the outset, walk them through scenarios where your approach should perform well, and explain which risk management tools you’ll use in down times.

Carroll says running and explaining simulations is time-intensive, but worth it. For instance, one of his largest investors gave him more money during a period of underperformance thanks to such explanations. “We see you’re down,” the investor said, “but it’s in a scenario where you said you’d be down. And, we’re impressed with how you’ve applied your risk management tools.”

Prepare for the future
In a non-benchmark world, static asset allocation isn’t enough, says Itah. Managers should start allocating portfolios by risks: cash, duration, credit, equity and correlation. And instead of setting an allocation to run for three years, for instance, managers should be taking advantage of opportunities as they arise, subject to that predefined risk profile.

They should also move away from narrow mandates (e.g., large-cap value equities) and broaden their asset classes. He predicts between 2013 and 2016, Canadian plan sponsors will increase their non-benchmark strategies by 23.1% at the expense of active equity, passive and cash allocations.

To prepare, every active manager should be comfortable with derivatives, short-selling, quant modelling, FX and commodities, Itah adds. “In the future, alternative investing will be the default method of active management. Hedge funds will be mainstream.”

This story originally appeared on our sister site,

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