But measuring fund managers’ performance by reference to that of other managers gave pension fund clients no protection against investment “style drift”. If the majority of fund managers decided to increase their investments in a particular asset class or geographical market, the others in the measurement group were under strong pressure to follow suit.
Sometimes these moves could be self-reinforcing, amplifying bubbles and busts: the more managers moved into (or out of) a particular asset class, the higher (or lower) the valuation of that asset class and the more (or less) other managers had to allocate to keep up.
That is why fund managers’ performance is now widely measured against a different standard, an index—particularly within individual asset classes.
Index-based performance measurement uses the universe of shares or bonds available for investment as the starting point for assessing how an active manager has performed.
The use of indexes in investment performance measurement represented a change from indexes’ first use: as a tool for gauging market or business sentiment. To be suitable for use as a performance benchmark, indexes have to be designed in a rigorous way. They must be transparent, constructed according to a consistent set of rules, and they should cover a set of stocks or bonds that are available for investment.
Peer group-based performance measurement won’t go away. But the search for a more objective, consistent way to gauge how markets work and how investors are faring has led to an increasingly prominent role for indices and benchmarks.
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