The Nigeria Stock Exchange recently announced that the Index Governance Committee of the Exchange “has reviewed the eligibility criteria for the NSE Pension Index (“The Index”) in line with changes in the regulatory and market requirements”.
According to the chairman of the committee, Mr. Abimbola Abdulazeez Babalola, “The review of the Index was made imperative by the need to ensure that it continues to represent the appropriate benchmark for evaluating the Pension Fund Assets equity portfolios and remain suitable for all market stakeholders. The review further takes into consideration the changes in guidelines as specified in the Pension Reform Act 2014 and Amended Regulation on Investment of Pension Fund Assets as advised by the National Pension Commission (PENCOM) as well as market requirements in the amendments”
About NSE Pension Index
According to the Nigeria Stock Exchange, “The Nigerian Stock Exchange in order to deepen the market introduced the Pension Index and exposed to the investing public in 2015. The creation of the NSE Pension Index has provided benchmarks tracking mechanisms for Pension Fund Administrators and other Users that follow the PENCOM guidelines. The NSE pension tracks the top 40 companies in terms of market capitalization and liquidity. It is a total return index and is weighted by adjusted market capitalization, a capping factor, and a free-float factor”
Appropriateness of the NSE Pension Index
As noted already and as avowed by the chairman of the Index Governance Committee, “The review of the Index was made imperative by the need to ensure that it continues to represent the appropriate benchmark for evaluating the Pension Fund Assets equity portfolios”, however, the question that comes to mind is to what extent is the NSE Pension Index, as constituted, an appropriate benchmark for evaluating pension fund portfolios? To answer this question, I will be looking at what an appropriate benchmark should be and take a look into the constituents of the NSE Pension Index in comparison to the asset allocation of pension funds in Nigeria.
What is a good Benchmark?
According to the CFA Institute, for a benchmark to be a valid and effective tool for measuring manager performance it has to be unambiguous, investible, measurable, appropriate, reflective of current opinions, and specified in advance. Without delving into the meaning and implications of all the qualities of a good benchmark noted above, I will be dwelling on the appropriateness of a benchmark. For a benchmark to be appropriate, it has to be in line with and account for the investment style or style characteristics of the fund or manager whose performance is to be evaluated by the benchmark. What that means is that, if a fund or manager invests in small-cap growth stocks, then the benchmark should be made up of small-cap growth funds. A benchmark that does not take into consideration the investment style of the manager or fund, will remain ambiguous when it comes to whether the fund or manager out or underperforms the index or benchmark.
How to test a Benchmark for appropriateness
The taste of the pudding is in the eating, the saying goes, in the same way, a good benchmark can be tested by performing a correlation analysis of the bench mark’s return versus the return of the fund or manager’s return. The higher the correlation, the better the benchmark. Analysts at Quantitative Financial Analytics carried out a correlation analysis of Nigerian pension funds and the NSE Pensions Index using beta, as a measure of correlation and the result is startling. The result indicates that there is very low correlation between pension funds and the NSE Pensions Index. The three pension funds with over 10% correlation coefficient happen to be those with the highest exposure to equities in their portfolio asset allocation.
The NSE Pension Index is made up of the top 40 companies and these companies full into the asset class of equities. However, 100% of the pension fund in Nigeria allocate less than 10% of their asset to equities and 90% to treasury bills and other fixed-income securities, therefore, using an index that is 100% equity-based to evaluate funds with less than 10% exposure to equities, is in my opinion inappropriate. It is akin to comparing apples and oranges. The NSE should come up with a customized index or Benchmark that lines up with the asset allocation or investment style of pension fund managers, otherwise, those fund managers will be charging pension funds for outperforming an index (especially during bad times for the stock market).