Benchmarking Costs Climb as Regulators Demand More Disclosure

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With the introduction of increasingly sophisticated investment strategies and asset classes like derivatives and private credit, benchmarking costs have risen in recent years. Indeed, as markets have grown in size and complexity, so have the costs of using benchmarks, such as stock indexes or private peer group data, for comparing performance against broader market activity.

Regulators such as the Securities and Exchange Commission have established requirements and general prohibitions for firms marketing performance, including the use of performance benchmarks.

For instance, Rule 206(4)-1 of the Investment Advisers Act of 1940 (the "Marketing Rule") stipulates that when registrants advertise performance, benchmark comparisons must be clear, relevant and include all context.

Regulators and compliance teams want to ensure that registrants exercise fiduciary prudence when choosing and disclosing benchmarks or that they publish relevant market conditions when no meaningful benchmark is available, such as for less liquid assets or highly complex strategies.

Investment professionals must be savvy and selective to implement benchmarks that are relevant to their investment strategies, but affordable as well. Many are finding more costly subscription options for benchmark data they used to get on demand for free or at a fraction of the cost.

While regulators do not stipulate the specific benchmarks registrants should use, performance presentations must not be misleading and must be fair and balanced. Cherry-picking benchmarks that put performance in the most favorable but not necessarily representative light is not going to pass the general prohibitions test. Getting the best fitting benchmark — especially for private markets — can incur additional challenges and costs that using a commonly known market indicator may not.

Presenting custom benchmarks can create additional benchmark integrity, but also increases disclosure challenges. For example, an accounting system may be incorrectly pulling in a similarly named benchmark constituent along with several others, resulting in a custom return that appears reasonable but is inaccurate. Each constituent in the custom benchmark must be disclosed, and that often leads to multiple subscription payments for a single benchmark.

Dynamic benchmarks that can monitor manager over/under-performance while staying within prescribed allocation constraints have all the challenges of custom blends and more. The need to dynamically adjust benchmark weights as a firm's allocations changes increases the operational and compliance complexities. Moreover, full disclosure of investment-specific benchmark allocations runs the risk of disclosing information that might tip off competitors to the underlying strategy.

Many opt to disclose market conditions in lieu of benchmarks and, per the investment performance services (ISP) agreement, keep custom benchmarks for internal and client use only.

Important standards bodies are shedding light on new ways registrants can satisfy both stakeholders and regulators. For instance, the voluntary Global Investment Performance Standards (GIPS standards), developed by practitioner-led CFA Institute, require firms to select appropriate benchmarks for each composite and pooled fund and to include those benchmarks in disclosed investment reports.

The goal of the GIPS standards is to help investors make informed decisions by accessing current and relevant data for measuring investment performance–and that includes best practice guidance for benchmark selection. Both the SEC and the Financial Industry Regulatory Authority (FINRA) reference the GIPS standards as a widely accepted investment performance resource in addition to publishing guidance of their own.

The SEC's Office of the Investor Advocate says benchmarking "is crucial" to understanding performance quality and mandatory disclosures should be tested to ensure that communication objectives (e.g., awareness, comprehension) are achieved.

Some firms are turning to free and publicly published exchange-traded fund performance data in lieu of buying or building custom benchmarks. Firms using an ETF as a benchmark will want to look to the GIPS standards for best practices on how to do this. The GIPS standards outline disclosures and which returns are best to present this type of information.

On the other hand, some of the new benchmarking services bring additional value-added benefits such as better analytics, customized indexes and advanced reporting tools.

Investment professionals need to conduct cost-benefit analyses of the benchmarks they are using or considering. Better aligned benchmarks — at a reasonable price — provide a better tool for performance evaluation, as well as more fair and balanced advertisements.

Depending on the nature and composition of a given fund or portfolio, benchmark data may price smaller funds and advisors out of more esoteric markets. As well, for less liquid markets, benchmark quality may be difficult to verify. For example, there can be significant timing lags when using benchmarks for private market assets whose weighted exposure cannot be accessed on a timely basis.

The rising costs of benchmarking has significant implications for investors, advisors and asset managers. As a result, regulators are scrutinizing the competitiveness of benchmark costs, quality, and accessibility to ensure that smaller firms and advisors (and by extension investors) are not disadvantaged.

By understanding the shift from free to fee-based benchmarks, stakeholders can navigate the evolving landscape and make informed decisions about their investment strategies and performance data needs. Investment performance professionals are well-positioned to help new or smaller firms choose a right-sized solution that is suited to their budget as well as their investment benchmarking needs.

Kim Cash (CFA, CAIA, CIPM, CSCP) is the founder of Cascade Investment Compliance & Verification. Janice Kitzman, CIPM, is a partner at Cascade Compliance and chair of the GIPS standards Verification Subcommittee.