CFA Society Netherlands: Benchmarks are important, so choose your benchmark wisely

September 8, 2023

^{This column was written in Dutch. This article is an English translation.}

Passive investing is the most common form of investing, although there is no real 'passive' of course. Passive investing is following other people's active choices, namely those of the benchmark compilers. The benchmark provider has thus de facto become a fund manager. All the more reason to choose your benchmark very carefully, also in view of the sustainability implications.

By Martijn Huijnen, Member of the Responsible Investment Committee of CFA Society Netherlands and Senior Policy Advisor at the Social and Economic Council (SER)

Investing starts with a need of a customer or participant. For example, a good pension over a number of decades or a good pension in a liveable world. Pension funds and other investors are increasingly incorporating sustainability preferences into their investment policies. For example, customer or participant panels can be used to investigate the concerns and wishes with regard to social themes, from climate and biodiversity to a living wage.

The benchmark plays an important role in the investment process. It is a means of measuring the performance of an active manager and a means of expressing investment risk. And for a passive investor, it's basically the investment portfolio. There is no investment risk, because risk and return are equal to the reference point. But a customer doesn't necessarily want to track an MSCI World or S&P 500. He wants a product that meets his objectives.

A benchmark can still be a solution to achieve that. The question then is: does the chosen financial benchmark adequately reflect the underlying needs of the customer? Because a lousy absolute return does not benefit the end user, whether or not there is underperformance.

Zooming in on sustainability, it is important to properly include customer needs in the benchmark. With passive investing, you (in principle) invest in the benchmark as composed by the provider. The benchmark provider thus functions de facto as a fund manager. Fiduciary advisers therefore have every reason to look very carefully at the benchmark composition and to opt for a tailor-made approach if necessary.

Service providers, from fiduciaries to benchmark providers, will also have to take a critical look at their own product range. Whoever offers a product must find the product ethically acceptable. It's great if customers want to invest more sustainably than your lower limit, but as a service provider you have a lower limit to monitor. Where it lies will be different per person and service provider. We will have to talk about this more often in our sector, all the more so because standards shift over time.

Fortunately, taking all stakeholders' interests into account, and not just the financial interest, is becoming increasingly important. For example, it is the cornerstone in the IMVB covenant in the pension and insurance sector.

Benchmark providers can then offer solutions in the form of more sustainable benchmarks in various shades of green (and red) and of course via customization. For smaller funds it can sometimes also be a solution to maintain a 'grey' benchmark and to pass on certain criteria to the asset manager for which a separate allocation is made.

In any case, it is important to be clear about what you expect from a fund manager. Agreeing on a benchmark with sustainability criteria can be a valuable tool in this respect. In addition, it is crucial to be clear to customers about the sustainability goals and exactly what the product does and does not do to prevent greenwashing. Benchmarks are just a tool. You can outsource its composition, as opposed to your own responsibility. And at that point, all players in the system have a role to play. Wishing you much wisdom!