You may have heard the phrase, “You cannot spend relative performance.” Should an investment portfolio focus on achieving defined investment goals or beating a benchmark? Investment professionals and even investors might agree that it is more important to achieve well-constructed investment goals, and yet many inevitably cannot help but compare their portfolio returns to the performance of other portfolios or benchmarks and then make investment decisions based on these often inappropriate comparisons.
Investors face numerous challenges when attempting to evaluate their portfolios. One of the most important and often overlooked variables that impacts portfolio performance is time horizon. For most institutional investors, that time horizon remains a long-term one, which has statistically proven to provide better investment results. What does focusing on the long-term mean? One way to look at it is not placing unreasonable expectations on the portfolio (i.e. comparisons against unrealistic indexes or other organizations’ portfolios which may have dramatically different objectives) which will ultimately allow the portfolio to extract the most amount of alpha over time and take advantage of market opportunities at the right moment. Two other factors that are key to identifying the right benchmark are risk and return.
Index-Based Benchmarks
In an environment where passive investments have significantly grown in popularity, an index-based benchmark represents one tool investors can use when evaluating composite performance. Index-based benchmarks can span a wide variety.
1) Narrowly diversified portfolio: for example, 60% S&P 500/40% Bloomberg Barclays U.S. Aggregate. One benefit of this more simplified benchmark is that it is widely used and the replication of this representative portfolio is relatively straightforward. With a narrowly defined benchmark, investors can easily grasp the benefits of asset allocation in their portfolio. On the other hand, we have also learned that in years when diversification has been out of favor, a broadly diversified portfolio will trail this type of benchmark even though the portfolio might still be in line to achieve the stated long-term goals agreed upon at inception. Moreover, broad diversification has generally outperformed less diversified portfolios over the long-term.
2) Broadly diversified benchmark: custom weighted average indexes based on the portfolio’s asset allocation. While utilizing a weighted average index as a benchmark is effective at evaluating underlying manager selection, it also has inherent flaws that should be carefully considered before relying solely on this type of benchmark. For example, not all indexes are investable and therefore, one may not have the ability to replicate one of the underlying indexes or perhaps due to excessive risk or volatility, it’s simply not advisable for a prudent investor. Exceptions such as these ultimately diminish the overall value of the comparison.
Goal-Based Benchmarks
Most, if not all, of our discussions with clients begin with a comprehensive understanding of their goals and DiMeo Schneider & Associates L.L.C.’s Three Levers approach or the identification of anticipated annual inflows, outflows and required return. This dialogue may also include factors such as risk or volatility tolerance, portfolio size and liquidity constraints, to name a few. While clients’ objectives can appear similar, they are rarely identical and therefore, we treat each of them as unique. Consequently, institutions and investors must compare their portfolios not only to a set index or custom group of indexes, but also to their progress in achieving their specific objectives. Time horizon gains particular importance here. Defining long-term goals allows investors to make near-term decisions that are more conducive to reaching these goals. Similar to index-based benchmarks, goal-based benchmarks can take on several different forms.
1) Spending % + CPI - Many of our clients incorporate a specific spending policy. Most nonprofit spending policies are based on a methodology that seeks to dampen the volatility of spending1. The dollars available for spending are determined by applying the spending rate (for example, 4.0-5.5%) to a moving average of 3 years, 5 years or some other time period. One challenge with this approach is that while some mitigation of spending volatility is achieved, the Uniform Prudent Management of Institutional Funds Act (UPMIFA) strongly implies that the spending amount (and therefore %) should fluctuate depending on the market environment.
2) Nominal % - Some clients aim to reach a certain level of assets within a specified time frame (for example, $100 million in 10 years). In order to achieve this target, they need a certain nominal % growth in their portfolio on average each year. Again, the complexity here is that with almost 100% certainty no portfolio will achieve that nominal number every year and maintaining a long-term horizon is critical. Nevertheless, this benchmark can be helpful as a means to evaluate how closely aligned a portfolio is to the stated goal and determine if greater risk may be required to achieve the goal (or perhaps have the luxury of reducing risk).
3) Volatility or risk-based benchmark - Conversely, some institutions know they cannot stomach a portfolio loss of more than an explicit amount and quantifying downside risk becomes more meaningful. For these clients, utilizing a risk-based benchmark might be helpful. One of the challenges with this is whether the historical risk assumptions utilized to establish the asset allocation match the historical risk assumptions of the benchmark.
4) Broader organization benchmark - Lastly, clients may compare their portfolio to one that is broadly published and followed by similar organizations. For example, many nonprofits reference the annual NACUBO-Commonfund Study of Endowments. While it is useful to periodically compare a portfolio with peers, the differences in goals, risk tolerance, access to managers, liquidity profile and size of portfolios to name a few characteristics, make it extremely difficult to simply compare a portfolio to an average. In many cases, averages are skewed to the upside or downside by outlier investors.
Proper benchmarking provides a critical framework for evaluation that can lead investors to make informed and prudent investment decisions in challenging years like 2008-2009. For the majority of clients, we advocate the use of at least two composite benchmarks as no single benchmark perfectly evaluates performance or adequately addresses an institution’s investment goals.
For further information and assistance with benchmarking your portfolio and defining your institution’s investment objectives, please contact any of the investment professionals at DiMeo Schneider & Associates, L.L.C. in order to make the most prudent decisions.
1Endowment Spending: Building a Stronger Policy Framework. By Verne O. Sedlacek and William F. Jarvis.
