Whether you already hold an investment portfolio or are in the process of building one, it’s important to understand how you can measure its performance now and on an ongoing basis. This might seem simple if you are only looking to get a reasonable return over that you might expect from a cash investment but, in reality, any investment other than cash necessarily involves an element of risk, especially in the short term.
If you have a clear idea how risk is quantified and how it translates into better performance (or not), you can make informed decisions about how your investments are managed. If you enlist an investment professional to manage your portfolio they should help you understand the trade-off between risk and return. However, you will also want to be able to measure whether your investment manager is adding anything to the risk/return equation.
“Benchmarking” is the method of selecting an appropriate index or model against which your portfolio’s return and risk characteristics can be measured, and we’ll look in more detail at the different factors involved in setting the right benchmark.
A benchmark is a yardstick against which you compare your portfolio’s returns. But it is only useful if it reflects your actual investment objectives and would be possible to replicate in the real world. There are some key characteristics that an appropriate benchmark should demonstrate:
Relevance to Your Objectives and Tolerance to Risk.
The first stage of setting up a portfolio and then measuring its performance is determining whether you are prepared to tolerate the risk of short or medium-term volatility in the expectation of higher long-term returns.
That tolerance to volatility risk can then be narrowed down and quantified by asking how far you could tolerate your portfolio falling in value (known as “drawdown”) over a given time period such as a day, month, year, or at all. Crucially, you would also want to know what the potential reward could be over the longer term for taking that risk.
If you are prepared to accept a high level of volatility, then a benchmark that is heavily weighted toward equities might be appropriate. If you are less comfortable with volatility, the benchmark would probably be weighted more towards bonds or cash type investments.
Sometimes the objective might be an agreed percentage over cash rates. Although this is more relevant to shorter term holdings than a long-term investment portfolio.
If your objective is to achieve long term equity-like returns but with no risk of volatility this, unfortunately is not realistic and there is not a portfolio of investable assets that could achieve this objective.
However, if you changed the objective to “moderate long-term growth with some risk of drawdown” then a number of realistic, investable benchmarks start to become available that might include a combination of assets including equities, bonds, “alternative” investments, such as hedge funds, and commercial property.
Whatever objective you adopt, the selected benchmark should be transparent as to the assets it holds. That doesn’t mean your portfolio must hold the same assets in the same proportions, but that becomes relevant when you measure your portfolio’s performance against the benchmark.
Often you may wish to compare the performance of your portfolio against portfolios with similar objectives managed by other investment managers or funds. If this is the case, then the competing funds or portfolios should also be transparent so that the reasons for under or over performance, and the levels of risk taken, can also be compared.
Both your own portfolio and the benchmark should be measured by the return after any management or transaction fees and also net of tax incurred in the day to day management. This makes it possible to judge whether the cost of active management is justified by outperformance and/or reduced risk.
Some common benchmarks might include:
Knowing how a portfolio has performed against a benchmark is useful, but you will also want to know what has driven the under or overperformance. At a basic level it might be that your portfolio has performed well from one point in time to another in terms of overall return, but at the expense of more volatility than the benchmark. Performance attribution looks more closely at this and will allow you to have a meaningful discussion with your investment professional when you review whether your portfolio continues to meet your objectives.
Although there are a number of other factors that can drive performance attribution, the following are the two most fundamental:
This is the weighting your portfolio has to the main asset classes such as equities, bonds, property, and alternative investments, such as hedge funds. These asset classes can also be broken down into more detail such as geographical allocation, capitalisation size of the underlying asset classes, e.g large companies, small companies, sovereign bonds, corporate bonds, and so on.
The relevance of this level of attribution is that your portfolio’s performance could have been driven by generally rising or falling markets in an asset class it had a weighting in. The performance against the benchmark, in terms of return and volatility, could be because your investment manager allocated more or less to an asset class than the benchmark. Knowing this will help assess whether that decision had a positive or negative effect.
This is often known as “stock selection” although your investment manager might also be investing in funds or other types of security. It looks at whether the performance and risk were attributed to more detailed decisions on the underlying holdings. An example might be if they chose to be overweight in large companies or technology stock within the equities asset class and underweight in sovereign bonds such as gilts, in favour of corporate bonds, within the bonds asset class. The attribution analysis will look at the effect these detailed decisions had on return and risk against the benchmark.
Benchmarking is a tool to compare your investment portfolio’s performance and risk characteristics against a yardstick that reflects your overall objectives. It follows that to make this relevant and useful you need to select a benchmark that accurately matches your objectives.
For most investors the main objective is capital return with a level of risk they are happy to tolerate and it is important to understand that the higher the growth expectation, the higher the level of risk you need to accept. Once you have decided on realistic objectives, you may wish to then to use a benchmark that quantifies this.
Using a blunt instrument, such as a stock market index, as a benchmark is unlikely to meet most investors’ objectives as there is no management of risk in the index.
If, however you used a benchmark that sets out the acceptable amount of risk compared to a generally understood asset class such as world equities, and then compares peer portfolios that have the same risk characteristics, you could make a meaningful analysis of how much return your portfolio has made, and with how much volatility compared to actual portfolios with the same objectives.
One example of a peer portfolio indices are those produced by investment analysis company ARC Research Limited, whom provide real-life benchmarking against actual risk graded diversely invested portfolios with varying risk and return characteristics. This allows a comparison of the performance of a managed portfolio against leading competitors and to question how well an investment portfolio has performed.
Asset Risk Consultants (ARC) Research Limited provide the Private Client Indices (PCI’s) and are used by approximately 140 private client investment and wealth management companies, taking performance and risk data from over 350 real portfolios. They are used specifically for discretionary private client portfolios.
ARC’s PCI’s collate data from all the investment companies that subscribe to them and risk grade them into 4 benchmark indices (the PCI’s). The risk is quantified as a percentage of that of world equities as follows:
Each portfolio is risk graded based on actual performance, regardless of its asset class allocation and then contributes to the construction of the corresponding PCI.
That means that, if you have selected as a benchmark the “Balanced Risk” PCI, your portfolio can be measured against that benchmark in terms of both return and volatility over given periods of time. It means that you are comparing your portfolio against actual peers with the same risk parameters.
The PCI’s also provide top and bottom performances of peer portfolios (without naming them) rather than simply an average. That way you can assess whether yours is above or below average.
They are also based on actual returns net of fees.
Questions to Ask When Assessing the Performance of Your Portfolio
When you assess your portfolio’s performance against the selected benchmark you should look at it over different time frames such as 1 year, 2-3 years, 3-5 years. It’s rare for a portfolio to always be in the top quartile of its peers but you should question the reasons if it is consistently in the bottom quartile.
You should also look at the performance attribution to gain an insight into where the returns (or lack of) are being derived and, if the drawdowns are at the high end of the risk category. Even if the returns are acceptable, excessive volatility may signal too much risk is being taken.
When assessing the performance of your portfolio it is not enough to simply look at returns. You need to know how much risk is being taken to gain those returns. In rising equity markets it is easy to make apparently healthy gains in value, but when markets fall those gains can quickly become insignificant
Selecting a benchmark against which to measure your portfolio is a powerful tool as long as it matches your objectives in terms of expected return and acceptable risk, so you need to be realistic about your expectations and tolerance to drawdowns.
Your objectives should be regularly reviewed with your wealth manager and if necessary changed so that your portfolio can be re-aligned, with a change of benchmark if necessary.
And, most importantly, ask questions of your wealth manager to gain a reasonable understanding of how returns are achieved.
The value of your investment can fall as well as rise and is not guaranteed. Past performance is not a guide to future performance.
One of our qualified and regulated advisers would be very happy to discuss your requirements.
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