This week, the Financial Conduct Authority (FCA) published new rules for asset managers regarding benchmark selection, which made me wonder whether discretionary fund managers (DFMs) could come under similar pressure later down the line.

Under the new rules, fund managers will be required to explain why they have chosen a certain benchmark to compare performance against or a specific target to work towards. The intention is to provide investors with better information about what a fund does and how to evaluate its performance.

In addition, fund managers will need to make sure their objectives are clear and they have disclosed any features of the investment strategy that are fundamental to how the product is managed.

Firstly, it is worth flagging that there are significant differences between the worlds of asset management and discretionary fund management: not least the latter’s focus on risk-adjusted returns.

Nevertheless, I believe the FCA’s approach underscores a determination to improve transparency across the value chain – and I suspect it is only a matter of time before DFMs and financial advisers come under similar scrutiny.

Discretionary fund managers featured on our website tend to use a range of benchmarks, including the MSCI WMA Private Investor indices, the Investment Association, as well as cash plus benchmarks. Meanwhile, others prefer to use customised benchmarks to reflect the bespoke nature of how they manage portfolios for clients.

So what does a ‘good’ benchmark look like?

If this is a question you are grappling with, here are a few pointers outlined by Dr Quintin Rayer, who is head of research and ethical investing at P1 Investment Management, which are worth considering:

» The index should be targeted, well maintained and unambiguous.

» It should be representative of the investment activities of the portfolio.

» It should be appropriate to the currency of the portfolio.

» It is easily measurable and its return can be calculated as frequently as needed.

» Ideally, the benchmark should separate out the relevant components of performance.

» The significant majority of individual investments made will be drawn from constituents of this index, with exceptions indicated and the degree to which off-index investments clearly stated.

» The future index returns would be representative of the level of future returns the end-investor can expect.

» The index risk level is representative of the risk level the end-investor can expect.

Due diligence processes

If you are in the process of selecting a DFM to work with or you are reviewing existing relationships, benchmark selection should form part of your due diligence process.

In the past, some investment managers have been known to change their published benchmarks to flatter their performance or to mask meagre returns – a situation which would represent a serious red flag if identified as part of your due diligence work.

This is why it is important to make sure the benchmark selected by a DFM is appropriate, consistent and fair. Adding benchmark selection to your due diligence process can ultimately add value for your clients by ensuring that you are selecting the most suitable proposition for their needs.