Core Focus: The two-layer benchmarking framework, the distinction between strategic and tactical benchmarks, the role of benchmarks in performance evaluation, and the practice of ranking managers against peers.
In-Depth Notes:
The benchmarking framework is a cornerstone of reserve management, providing a transparent and objective standard against which the performance of the reserve portfolio is assessed. The ECB, for example, uses a two-layer benchmarking framework: the Governing Council establishes a strategic benchmark for each currency, which reflects the long-term policy requirements and risk and return preferences of the ECB; the Executive Board determines a tactical benchmark, which is kept within pre-set bands around the strategic benchmark and reflects the short- to medium-term risk and return preferences of the ECB .
The Strategic Benchmark:
The strategic benchmark is the long-term, policy-driven portfolio that reflects the SAA. It represents the expected risk and return profile of the portfolio if it were managed passively, without any active management decisions. The investment objective is to maximize expected portfolio return under the constraint that there are no losses at a 99% confidence level in each individual year over the five-year investment horizon . The strategic benchmark is reviewed annually and rebalanced monthly.
The Tactical Benchmark:
The tactical benchmark allows for medium-term adjustments to the investment strategy in response to changing market conditions, while still providing a reference point for performance measurement. The objective of the tactical benchmark is to outperform the respective strategic benchmark within an investment horizon of three months . It is reviewed monthly and rebalanced monthly.
Performance Ranking:
A distinctive feature of the ECB’s framework is the monthly performance ranking of managers. The ECB draws up and distributes an updated ranking among NCB portfolio managers on a monthly basis . This ranking is seen as an important risk motivation among portfolio managers. Some managers seemed to increase their relative risk taking in the second half of the year if they reached a lower position in the first half, demonstrating the behavioral impact of the ranking system.
Hybrid Benchmark Structures:
Some central banks employ sophisticated, hybrid benchmark structures. The Bank of Israel, for example, sets a currency benchmark—a basket of currencies that will be used, in addition to the shekel, for measuring the rate of return on its foreign exchange reserves . As the rate of return on the FX reserves is also measured in terms of the currency benchmark, its composition is defined as the risk-free currency composition for the reserve portfolio managers. It then ensures its asset exposures are aligned to the basket from an FX exposure perspective.