Until the late seventies equity investment portfolios were primarily judged on their overall efficiency. Benchmarks emerged later. The purpose of the benchmark is to measure the performance of the fund manager relative to a representative index. Indices whose weights are proportional to the market value of a company were chosen on the basis of scientific arguments. In this short article we argue that investors such as pension funds will benefit from taking a closer look to and call into question the composition of their benchmarks. We state that pension funds will benefit from the use of ‘smart’ benchmarks. Market Value-weighted Indices Market value-weighted indices are compiled by index providers. They decide which listed companies are included in the index. Subsequently, the index weight is determined by the value of the company on the stock exchange. This allows investors to indirectly affect the weight of a company in the index. The index weight of stocks that rise faster than the market will increase and the weight of stocks that lag behind the market will decrease. For example, the price of Apple shares rose from $95 in 2008 to $700 in 2012. Simultaneously the index weight in the world index grew from 0.45 percent to 2.45 percent! The advantage of index weights that automatically move along with the price movements is that weights automatically adjust. There are no transactions necessary on the stock exchange, as long as the index does not change in composition. However, more recently the disadvantages of market capitalization weighted indices were identified: * Sub-optimal diversification In general, marked capitalization-weighted benchmarks do not necessarily have optimal diversification. Stocks are simply selected by the index provider because of their market value. Expected returns, risks and correlations do not play part in the selection at all. The potential benefits of a smart way to deal with correlations and risks are not used. * Risk concentration The name of the index remains the same, but the risk of the benchmark changes every day. The weights of stocks, regions and industries fluctuate over time due to the focus on market values. In other words, an investor who follows a market value-weighted index takes risks that he does not actively manage himself. He leaves choices about certain risks to other investors in the market. New Insights Both scientists and asset managers recently made substantial progress in their thoughts about market value-weighted benchmarks. New insights have led to the creation of investment strategies that react less on the market capitalization of stock. The main developments are the emergence of theme benchmarks based on specific stock characteristics other than the market value, just like a Minimum Risk benchmark. Recent academic research also provides evidence that there are attractive alternatives to market value-weighted benchmarks. Theme Benchmark Portfolios Based on Stock Characteristics The first logical step in the release of “market value-weighted index”-thinking is a benchmark weight based on other enterprise or stock characteristics than the market value. The book value of equity, revenue and equity beta are enterprise characteristics that can be eligible. The great advantage of this weighting scheme is that emotions on stock markets resulting in daily price movements influence the composition of these benchmark portfolios less. The investment strategies behind these benchmarks are systematic and do not require return forecasts. Benchmark portfolios in which the weights are based on the book value of a company are also known as ‘Fundamental Indexation’. Just like market capitalization weighted benchmarks, using book values for benchmarking, will make people invest more in larger companies than in smaller companies. The realized returns on ‘Fundamental Indexation’ benchmarks and market capitalization weighted benchmarks can vary considerably, there is a high tracking error. ‘Fundamental Indexation’-strategies had better returns historically. A disadvantage however is that a theoretical underpinning for such a weighting scheme is missing in our opinion. Benchmark Portfolios Based on Minimum Risk Minimum Risk benchmark portfolios let go the use of market value-weighted benchmarks. A Minimum Risk portfolio is a portfolio that –on the basis of one or more risk models- has the lowest expected risk of all potential equity portfolios. Such portfolios have been known since the pioneering study of Markowitz in 1959. During the last few years these portfolios have become increasingly popular. The advantage is that yield predictions are not required. The portfolio can be assembled without any expectations of the expected returns. This is a great feature when there is much uncertainty about the expected return of individual stocks, while there is more certainty about the risk of a well-diversified equity portfolio. Minimum Risk portfolios are systematic strategies and are constructed based on optimization routines, risk models and transaction cost models. Besides striving for the lowest possible risk, further demands on Minimum Risk portfolios are required in practice too. The maximum weight of each share is usually limited, as well as sector and region weights. Also, the sales and style influences are limited. These additional requirements are intended to create a neutral yield, alternative to market capitalization-weighted investing. In practise, Minimum Risk portfolios have a twenty to thirty percent lower volatility than market value-weighted indices. Empirical analyzes based on historical data shows that the Minimum Risk strategy yields higher returns than market value-weighted benchmarks. Due to lower risk and higher average returns Minimum Risk strategies show attractive Sharpe ratios for most equity universes: the world, the United States, Europe and emerging markets. These historical analyzes show that Minimum Risk portfolios are more efficient than traditional market value-weighted benchmarks. Obviously, the risk reduction applies to the time the portfolio is made (ex ante), but also appears to apply to the actual risks (ex post). The volatility of the portfolio is generally reduced by twenty to fifty percent. The biggest reduction in risk will be achieved in periods of high market volatility such as the credit crunch. This is exactly the time when pension funds welcome risk reduction the most. Smart Benchmarks and Pension Funds Perhaps the most important development is that smart benchmarks become accepted by pension
Interview Fred Paling
Could you give a brief introduction about yourself, what you have studied and how your career looks like so far? I was born in 1962. After high school, I started studying economics. At one point I started to combine studying and working, as my girlfriend and I wanted to live together. I then started working for the government psychological service. in the 80’s it was not so good with the economy and the government had to make several cuts. As a result, many officials were dismissed. I started working at the department that was in charge of the reintegration of officials. At one point I got a new job as a management consultant. This took so much time and effort, I quit studying in the last year of my doctoral. My work during this period in the psychological realm service consisted mainly of writing a business plan and setting up again this government department on a prudential reads. Some time before I left the governmental psychological services I thought it was pity that I did not have my degree completed, so then I completed an MBA with honors. Then I joined another component work of the Ministry of the Home Affairs where I was deputy director. This was the department of information where public officials dealt with the automating payroll. Then I was asked as policy director but I thought this function would not fit me. I’m a real do- person and I felt not to be so good at only thinking and writing without seeing actual effects. Eventually I went to the Ministry of Health, Welfare and Sport. Here I occupied myself with the management of the ministry, everything that has to do with personnel and finances. After that I started working at the Institute for Employee Benefit Schemes (UWV). This was a exciting challenge as social security was previously privately arranged and this was a national changed regularly implementing organization. In 2004, I became head of the employability division where the WAO, WIA and sickness are part. Finally, it has been three years from now when I was asked to join the board of directors. What is your concrete drive for working in the public sector? I do not think that money is most important and I like to do some meaningful work. I have always felt that meaningful work in public domain works best for me. So that has been initially the first reason to work in the public sector. When I worked once there, I became fascinated (and I still am). The implementation, services and the political-administrative domain give enormous complexity and enormous surprising points all the time. There are people who end up in the public sector, after three months saying: “That’s not for me.” Well, I like it. What are the precise purposes of the UWV and in what way do they add value to society? The UWV has a number of goals, but I summarize it briefly to: “we prefer working instead of payments.” Our primary goal is to prevent people needlessly lose their jobs and if they do still have lost, to help them as quickly as possible to get back to work. We also provide a period in which people have temporarily no work deputy income benefits. Another task is to assess whether people are sick and to what extent they can do some tasks. Does the judging expire random or systematic? It is not random and it is not systematic. Anyone born incapacitated or who became disabled and got limitations before 18th can appeal to a scheme for a custom workplace and to financial support. The approval happens in advance. Before a decision is made, the person in question is inspected by an insurance doctor who assessed what you cannot and what you still can despite your disability. Then a functional assessment list is made. Everyone is approved in advance; there is no sampling or something like that. How does the UWV get their money and how is it spent? The UWV is funded by the government, the financing of the UWV is part of the State Budget. There are schemes such as unemployment and the WIA that still know the form of premiums. For 2002, the spending on benefits was fully covered by premiums that were paid in funds. The premiums go into the state budget and the benefits go out. It may be that the premium income is lower than the spending on benefits, because it runs over the national budget this is possible. The UWV can spend money on benefits but also on all kinds of facilities to keep people working and help people to get work. In addition, the UWV also spent money on itself, salary for 19,000 employees personnel, computer systems, buildings and so on. Is the UWV is also engaged in Corporate Governance frameworks such as the Code Frijns? Code Frijns does not apply to us. However, the government keeps very busy with governmental issues and, therefore, issues related to self-administrative bodies (SAB) as the UWV. For SABs there is a law which describes, among other state that the UWV exists, what its responsibilities are and in which the structure of the SAB comes forward. It is also mentioned that the minister is responsible. The political leadership my not take place at case level. The minister should not interfere with individual cases, so this also applies to the UWV. Is the UWV further engaged in Corporate Social Responsibility? Many companies include this in their operations in order to contribute something to society besides their primary goal. This is different for the UWV, however; UWV exists because of a societal goal of a new job or income replacement care for people who lose their jobs. This does not mean that we do not concern ourselves further with CSR. For example, also UWV a topic such as environmentally responsible actions are high priority and ensures the UWV that also people in less privileged positions get
CHANGING SUPERVISION
Supervising, or the supervisory function, is becoming increasingly important in the Netherlands. This is due to the financial crisis and the banking crisis. In both crises there is a reference to inadequate supervision. Appropriate or not, this leads to attempts to reform the supervision. There should be more supervision and this should especially be stricter. Thereby, it is implicitly or explicitly assumed that such crises will not recur, or will be contested earlier in the future. I do not believe this at all. Institutional reforming is needed, but is not a panacea. Are rules not helping? In the file part of FD Outlook, the quarterly magazine of the Financieele Dagblad, July 2013, Steven de Waal writes, often known by ‘Social Entrepreneurship’, on page 31: “If there is one lesson to draw from the series administration scandals of recent years, it is: rules do not help.” According to him, we have to go back to square one. Ethics and character building should be high on the agenda of management studies again. Codes of good governance seem to be like a Boy Scout oath in the world of power and greed in the boardroom. With that I mean ‘boardroom dynamics’, where even the seating arrangement matters! Two types of supervision In the first place there is Internal Supervision within the enterprise. The Supervisory Board practices this type of supervision. External Supervision is being held on whole sectors. There are many External Supervisors and their number seems to increase. That is causing more and more problems, which I will discuss under the next headline. There are two possible models of Internal Supervision. Firstly, there is the two-tier model, which is common in continental Europe. In this model there is a Board of Directors, which is the executive of the company, and a Supervisory Board, which supervises the actions of the Board of Directors. These are different responsibilities that are organized separately in this model. Until early 2012, this was the only accepted type of internal supervision in the Netherlands. There is also the one-tier model that used to be the standard in Anglo-Saxon countries, but since last year this model is also permissible for Dutch companies. Both responsibilities are still separated, but less strictly and less separately organized. They are part of the same body, ‘the Board’. Both models have their pros and cons. The one-tier model seems to becoming more popular in recent years in Europe. In England, where the one-tier model is in practice, there has been a mandatory review of the Boardroom for years. An important conclusion drawn form these evaluations, is that even the seating arrangement within the Board is meaningful! UK members prefer more discussion and less presentation. Particularly when it comes to strategy. They prefer to discuss risk management in the Council as a whole, rather than just in the Audit and Risk Committee. The seating arrangement at meetings of the full Board could be improved. Often the executives and non-executives are facing each other with their two presidents (Chairman and CEO) seated in the middle. One can guess what might happen quickly: both positions are not only seated against each other, but they will also disagree sooner. The metaphorical will become visible! The meeting will become more effective once they will no longer be sitting facing each other, but mixed up, say the non-executives. Whatever way the Board is organized, two-tiered or one-tiered, the call for further professionalization of the Supervisory Board is increasing: no longer recruiting amateurish from the old boys’ network, but increasingly on the basis of expertise, experience and track record. It increasingly involves financial and legal expertise, but soon also professional and business ethics. In short, supervision is changing rapidly. An article by the revealing title “Five red flags when you know your CFO is up to no good” circulated a while among Dutch commissioners after the Enron crisis early this century. Geertjan Stoker (Dutch Consultancy Risk Management) identifies the following signs of “big trouble”: (frequent) replacement of the management, underperformance relative to the sector, unclear changes in accounting policies, lawsuits, a lack of strategy, expanding terms of payment and a poor relation with stakeholders and external supervisors. He wrote this on account of his experience with the management crisis of the Amsterdam school group Amarantis. The business program at the University of Groningen includes classes in ethics as well. Once you have completed such a class, you are able to recognize moral aspects of management decisions and to understand your own responsibility for these decisions, to deal with moral dilemma’s in accounting, management and international business and to appreciate the moral role of the individual within the organisation. What about external supervision? There has been a lot more developments regarding external supervision. The number of supervisory bodies is increasing rapidly, but due to that also their duties and responsibilities. Who does not know De Nederlandsche Bank (the Dutch Central Bank) and the Autoriteit Financiële Markten (Financial Market Authority) in the financial world, and the Autoriteit Consumenten en Markten (Authority for Consumers and Markets) in the broader economic perspective, but with specialist focus the Voedsel- en Warenautoriteit (Food Safety Authority), the individual Inspections for Labour, Education and Health. A seemingly endless series of authorities is supervising. And then I forgot to mention European authorities like the European Central Bank. De Nederlandsche Bank (DNB) has received much criticism for its performance during the financial crisis. At first they have not recognized the crisis and its potentially large impact on financial markets and financial institutions or have recognized it too late. Then followed lax and inadequate responses. The consequences of the bankruptcy of Lehman Brothers were underestimated, the situation at DSB Bank had gotten out of hand, they did not act at all at ABN AMRO, and so on. At the end of his career Bank President Nout Wellink has been made scapegoat. Wellink was not reappointed and prematurely sent into retirement, rightly or not. Intended successor Lex Hoogduin was written off by
