Beating Benchmarks

Abstract

The inability of active managers to consistently outperform capitalization–weighted benchmarks can be explained by a mismatch between those benchmarks and the underlying nature of active management. The authors show that this mismatch cannot be effectively addressed either through macro–level risk controls or through improved stock selection. They develop a new approach to risk management that emphasizes diversification at the individual stock level and offers significant improvements in risk–return efficiency and portfolio manager consistency; This new approach to risk management is also significantly easier to incorporate into a bottom–up investment process. Plan sponsors can further can further improve the value of active management through combinations of new, more portfolio manager–friendly active manager benchmarks and completion indexes that move the overall allocations back to their original capitalization–weighted benchmarks.