Benchmark Departures and Total Fund Risk: A Second Dimension of Diversification

Abstract

Standard asset class benchmarks are efficient in controlling and measuring investment performance on portfolio segments. This operational efficiency, however, can impede economic efficiency by inhibiting return-seeking departures from the benchmarks. Some strategies may be penalized merely for producing risk relative to the benchmarks, even if they add little or no risk to the total portfolio. For benchmark departures that are weakly correlated with the major portfolio risks, a “total fund effect” can greatly improve a fund's risk profile overall. Tactical and strategic departures whose value may appear marginal relative to asset class benchmarks can show attractive reward–risk ratios for the overall fund, if they can credibly promise incremental expected returns. This line of reasoning argues for granting increased latitude to any active managers in whom the fund has placed its confidence.