What is the motivation for index benchmark?

I know that many funds have local index (i.e., SPX in US) as their benchmark. Why are investors interested in such kind of returns instead of absolute returns. From the first glance I'd think one would only care to make the maximum amount of money rather than be positive in relation to some index. I often hear how people talk about "if everything falls 50%, but your allocation falls 48%, that's like +2%". At the same time I can't understand why wouldn't you then invest in absolute return fund which might actually make money in this period, and in such case could be considered over +50% return if it is so important to outperform index...

So, the question is: why funds with index benchmarks exist and who is interested in such, versus absolute return.

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Summary Answer: Those are interested to benchmark against indexes who sell such index products (pricing data, trade marks, rights to use and publish), and of course portfolio managers because they look generally much better when indexed against indexes than when being assessed through risk-adjusted returns. The general public is sadly just too uninformed to complain much.

Cynical and Winding Answer:

For the precisely same reason than airlines asking you to fasten your seat belts. Its not that a seat belt would make the slightest of differences when a plane crashes, but it makes people feel safe and cared, you know, that warm fuzzy feeling, when during 2008 your investment advisor called you up and cheerfully let you know that his stock picks performed 10% better than the overall market. Unfortunately you lost 40% of your market value.

I take a very critical approach to most motivations by market practitioners in the financial arena. What I have learned early on is that 1-2% are truly smart and outstanding alpha generators, another 8-9% perform vital and important support functions to sustain the 1-2% alpha generators, and all the rest in this industry are like pilot fish around sharks (defined as parasites and those feasting on leftovers). There is a whole indexing service industry subculture where such sales men arrive at your office to tout their latest wares in custom tailored suits, sun-tanned faces, wrist watches twice the size of their arms. The first time you see it you will be amazed, then surprised, and in the end you will run out of the meeting room screaming because you realized that a lot of your retirement and investment portfolios is eaten up by such people. They wine and dine your portfolio managers and he insists along all his colleagues during the daily investment meetings that portfolios must be benchmarked against indexes they themselves choose. A portfolio manager's, or better, fund sales person's worst nightmare is the term "risk adjusted return metrics".

Am I being cynical or bitter? Cynical yes, bitter no, but as soon as you witness just enough of the shenanigans that most in this industry are engaged in you gotta start laughing and smiling a lot more which is often taken as cynicism.

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Well, I do understand the motivation from the funds' perspective - they do what they can and advertise it. But it must be some clients' demand here as well. I mean, these are clients which bring money and thus create the demand for such a benchmark... –  sashkello May 14 '14 at 8:38
The cynical part I get very well, mate, believe me, I know what you are talking about. –  sashkello May 14 '14 at 8:41
The general public is simply too uninformed to critically overthink this practice. And anyone who buys funds as proxy is in the same bed with the buy side industry. Street knowledge on average goes as far as "buy and sell", most people have never even heard of indexes such as Russell, MSCI, and the like –  Matt Wolf May 14 '14 at 8:42
Everyone's a grown up when they invest. You lose money, your mom and dad won't be there to help you out... Basically if you invest in a fund that looks great benchmarked against SP500 and you realise that you have small cap value instead, that's your fault! Know what your buying. Ironically, benchmarks help you in this case - as long as you know what you're doing –  user3264325 Jun 1 '14 at 11:15
@user3264325, I am not sure this is a prudent approach. Guess how we all ended up in the midst of the biggest financial crisis since 1929: The "big guy theory" did not work all that great with banks, hedge funds, even money market funds; it does not work well as long as money is involved. We need prudent business practices and regulations, not to limit our freedom but to provide checks and balances because money managers are certainly not holding themselves to fiduciary duties because they truly enjoy doing so. –  Matt Wolf Jun 1 '14 at 14:39

The first reason is the answer to this question :

should I bother invest in your fund and not simply invest in the S&P500 etf ?

The second is :

Are you a fraud ?

If someone claims to use a long only strategy with stocks from the S&P500, you expect his fund returns to be correlated to the S&P500 to some extent. If it is not the case => fraud.

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Not necessarily, you may have just forgotten to read the fund prospectus, where it clearly states, that there is a management fee of x%, a performance fee of ..., that there are lending and borrowing fees, that there are so many various fees involved that the fund performance "may" deviate from the index performance. To be fair, an index is an index, it does not suffer from costs of execution, but that exactly is my criticism in my own answer. –  Matt Wolf May 14 '14 at 8:44

There are a few things:

Non-cynical:

• Active absolute return managers tend to underperform passive benchmarks after fees. So if you can get a manager that can outperform a passive benchmark (perhaps who has a mostly passive strategy with some active tilts), then you are doing well.
• Your scenario of a portfolio dropping 48% is not realistic. Most asset allocation guys will diversify with safe haven assets that are negatively correlated with typical risky assets during market turmoil. This could include gold, USD, CHF, US bonds, a negative beta manager, or some financial engineering products. Thus your expectation in a crisis might be better than only going to absolute return under certain allocations (and it wouldn't be - 48%). The key is to think on the allocation level instead of the level you were thinking of which is the manager level.

Cynical:

• The boards of pension funds and endowments will fire you if you do not make some acceptable quartile of performance among peers. Even if you are max $E[R(t)]$ and min $\sigma(R(t))$ by investing in absolute return in a statistical population sense, it is completely irrelevant to career risk. By choosing absolute return you will be maximising the variance of your returns around your peers (peer-relative tracking error), thus maximising career risk. If it comes to a trade off between career risk and the lower utility of your clients, the manager of the endowment and its investment consultant will choose to lower the utility of their clients (in my experience). (Liquidity providers are demonised, but who are the real cancers here?)
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But are you not omitting the actual metric, absolute returns? The issue is that most portfolio managers and almost the entire buy side industry hides behind relative performance. Because of this the incentive to produce alpha diminishes because it would mean that you have to take on risk or take a specific non-conforming view. But fact is that regardless of performance, whether positive but most often underperforming indexes or absolutely negative, relative performance to indexes is touted as a means to market such funds. –  Matt Wolf May 15 '14 at 4:40
And your last point, while valid, only applies again to relative performance. Yes you may get fired if you underperform all your peers, but nobody questions you nor fires you if even the top performer lost a sizable percentage of money invested. Because of that hardly anyone in the conventional buy side industry (hedge funds excluded) truly searches for outstanding but unconventional trading ideas. I do not only fault the PMs, it is the whole regulatory framework that is to be blamed. The term "Long only" should not even exist in our industry. –  Matt Wolf May 15 '14 at 4:45
Matt - alpha is a relative measure in itself... ; ) –  user3264325 Jun 1 '14 at 11:21

It's called "keeping up with the Jones." A lot of people are less worried about how much money they will make, than whether they keep up with (and therefore get to live and retire in the same style as) their friends, coworkers, or some other reference group. That applies to most fund trustees. Most of them like to compare notes with their peers on the golf course, and their primary concern is NOT to be "embarrassed."

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Why do index benchmarks exist?

Benchmarks are needed to quantify alpha. It's a relative measure after all

Why invest in slightly more passive index relative funds over absolute return?

Index tracking funds are popular because of a wide spread belief in market efficiency

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This answer is really not explaining anything. I know what a benchmark is, I'm asking why would it be a good measure of fund's efficiency, as well as why would people be interested to invest in it. How it is connected with market efficiency is also unclear. –  sashkello Jun 1 '14 at 11:20
Well if you want to calculate the alpha of a fund you need a benchmark's returns to do that. E.g. link –  user3264325 Jun 1 '14 at 11:25
Market efficiency basically tells us it's hard to beat the market on a risk adjusted basis which encourages people to invest in indicies which capture large swathes of investable assets (e.g. bond or equity indicies) –  user3264325 Jun 1 '14 at 11:29
Again, I'm not asking what is a benchmark and where it is used, but why does it come into play at all. Why would someone want to compare returns to a benchmark rather than to 0. –  sashkello Jun 1 '14 at 11:42
Well because we're always interested in risk adjusted returns, which need to be measured relative to an index. If you make large returns but take on massive risk, those large returns aren't very interesting... Everyone talk about alpha, everyone needs an index to measure alpha. –  user3264325 Jun 2 '14 at 2:24