What Benchmarks are currently used by Institutional Investors?
The two main types of benchmarks used in the UK are external asset-class
benchmarks and peer-group benchmarks. Peer-group tracking is much more
prevalent with pension funds and mutual funds than with life funds. However,
the use of customised benchmarks that reflect the specific objectives set by
particular funds is increasing. Benchmarks influence the type of assets selected
and, equally significant, the type of assets avoided. Peer-group benchmarks
have a tendency to distort behaviour, particularly when combined with a fee
structure that does not promote genuine active management. The outcome tends
to be herding and closet index matching.

What are the alternatives?
The main alternatives are: single-index benchmarks with time varying coefficients,
multiple-index benchmarks and fixed benchmarks. The first two alternatives have
recently been discussed in the academic literature but have yet to catch on in the
practitioner community.

Benchmarks based on liabilities
These are generally related to real earnings or consumption growth or to the discount
rate on liabilities. Explicit liability-based benchmarking is currently not very common,
but is likely to become so in the light of both the increasing maturity of pension funds,
various regulatory and financial reporting developments, and the Myners Review
of Institutional Investment. Liability-driven performance attribution explicity takes
the liabilities into account.

What happens in other countries?
The US has similar external asset-class and peer-group benchmarks as the UK.
Other countries use fixed or bond-based benchmarks.

Conclusion
Benchmarks are important, but so are fee structures. They can either provide
the right incentives for fund managers or they can seriously distort their
investment behaviour.