Investment Performance Benchmarks - How to Select the Best

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1 A Guide to Investment Performance Benchmarks

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3 Your trust s investment portfolio outperformed its benchmark by 1.5% in the most recent period. Terrific performance, yes? Maybe. It depends on whether a given benchmark is appropriate for a portfolio s investment strategy and allocation. Investors in today s environment must establish and construct their benchmarks with care. While there is no single best approach to constructing a benchmark, investors need to understand what questions can be answered and what questions can t by comparing investment performance to a benchmark. Charitable remainder trusts allow donors to achieve their philanthropic goals while also receiving income during their lifetime. Upon the donor s death, the remaining asset value is transferred to the charitable remainder beneficiary organization. Donors are often concerned with the level of income they receive during the term of the trust, while the charity s long-term interest is in the remainder value. Given this split interest, the objective for managing a charitable remainder trust investment portfolio is often a combination of growth, to help maximize the remainder value of the gift, and income, to support the recurring payments to the beneficiaries. In order to meet these objectives, most planned giving portfolios include both equity and fixed income securities. Selecting a benchmark for a portfolio that invests in a single asset class is relatively straightforward. For example, a portfolio invested in U.S. small cap stocks should be benchmarked against the Russell Small Cap Index, which tracks the universe of domestic small cap stocks. The performance of a portfolio of emerging market debt should be measured against a broad index of emerging market debt, such as the JP Morgan Emerging Markets Bond Index. For a multiasset class portfolio, however, the construction of a customized benchmark requires additional consideration in order to capture the performance of the manager in each asset class as well as decisions about how to allocate capital across various asset classes. 1

4 According to the CFA Institute, there are a few guidelines that should be observed in the benchmarking process. First, the benchmark should be established before the start of the investment period. Allowing a portfolio manager to select a benchmark at the end of the period would permit the choice of a benchmark showing the most favorable comparison. Second, the benchmark chosen should be appropriate for the portfolio management style and reflect current investment options. If the portfolio manager will be investing in large and small cap stocks, then the S&P 500 index would be a poor benchmark, as it captures the performance of only large cap stocks. Selecting a benchmark not aligned with the investment allocation reduces the ability to measure the success of the portfolio manager s decisions. As we will discuss shortly, different indices should be combined in a way that captures what the institution would like to measure. Most importantly, the portfolio s benchmark should be clearly understood by both the investment manager and the investor or institution. A benchmark for a multi-asset class portfolio combines several market indices and weights them to create an aggregate blended benchmark for measuring the performance of the entire portfolio. A key consideration is the degree of specificity in the benchmark to capture both asset classes and sub-asset classes. One choice is to construct a benchmark from indices that capture broad asset classes, i.e., equity, fixed income, and alternative investments. If your portfolio s equity component beats its equity index over a long time period, then the manager can be credited with good asset allocation decisions within the broad equity asset class. Alternatively, the benchmark could combine indices that measure sub-asset classes large cap equity, mid cap equity, small cap equity, emerging market equity, etc. Combining a larger number of indices permits measurement of the performance of each constituent part of the portfolio, i.e., How did the Emerging Markets Debt manager do relative to the Emerging Markets debt index? When selecting the underlying indices it is important to bear in mind how each index is constructed. There are two primary ways indices are constructed market capitalization weighted, and price weighted. A market-cap weighted index will be skewed towards the performance of the largest capitalization companies in the index. So in today s S&P 500 index, the performance of the index s largest market cap stock, Apple (AAPL), has a greater impact on the performance of the index than a smaller market cap stock in the index. A priceweighted index, such as the Dow Jones Industrial Average, weights its constituent stocks based on their prices. For example, a Dow stock trading at $50 has five times the weight of a $10 stock. 2

5 Key Considerations for Some of the Most Widely Used Indices Standard & Poor s 500 Index This is a market-value weighted index that comprises 500 large cap U.S. stocks. Pros: Familiarity of the index. It is easy to purchase low-cost funds that track the index s performance. Con: Does not include small cap stocks. Dow Jones Industrial Average Index This is a price-weighted index composed of 30 large cap primarily manufacturing companies. Pros: Familiarity of the index, ease of access to performance data, long history dating back to Con: The index is not an accurate representation of the broader economy or stock market. MSCI All Country World Index A market-cap weighted index comprising large, mid, and small cap stocks across the U.S. (45% of the index), developed international countries (38%) and emerging markets (17%). Pros: Single index solution for an equity portfolio that invests around the globe. Investors can purchase ETFs tracking the index for low relative cost. Cons: The owner of the index, Morgan Stanley, charges licensing fees to see the index components. The index may not be in line with the portfolio manager s equity asset allocation. Barclay s Capital Aggregate Bond Index Market cap weighted fixed income index of investment grade securities. Pros: Provides broad representation of the fixed income market, recognized as the primary U.S. fixed income benchmark by most investment professionals. Cons: The index does not include municipal bonds, Treasury Inflation-Protected Securities (TIPs), or below investment grade securities. 3

6 To measure the effectiveness of asset allocation decisions, hold index weights constant in your benchmark. There are two primary ways to weight the underlying indexes in the benchmark. One approach is to adopt a static policy benchmark. The other approach allows for dynamic reweighting of the underlying indexes. With a static benchmark, the weighting of each of the constituent indices is held constant at the level reflecting long-term targets for the investment of the portfolio. This approach allows you to measure the effect of asset allocation decisions within the portfolio. For example, if the investment manager has maintained an overweight allocation to U.S. large cap equities relative to the policy benchmark and U.S. large cap equities outperformed other asset classes, the comparison to the benchmark would capture this outperformance. One drawback to this approach is that it may prove difficult to identify whether portfolio performance is due to asset allocation decisions or to the performance of specific managers within the overall asset allocation. However, assuming the investment manager is making both asset allocation and fund manager decisions, a static benchmark holds the manager accountable for all decisions and reflects the total value the manager is providing the institution. The other benchmark approach reweights the indices dynamically as of the beginning of each measurement period. This approach allows you to measure the effectiveness of the active managers chosen for each segment of the overall portfolio. The impact of active asset allocation decisions made by the portfolio manager is eliminated from the comparison between portfolio performance and benchmark performance. This approach helps organizations that utilize actively managed mutual funds to identify if the active managers of their mutual funds have performed well. Conclusion Comparing portfolio performance results to a benchmark is inevitably a shorthand measure. Whatever the difference between the portfolio and the benchmark performance, you should ask, Why did the portfolio perform this way? If your portfolio outperformed its benchmark, did the investment manager take more risk than the benchmark? Did active management help or hurt performance? Did wise asset allocation decisions generate the outperformance? Conversely, in periods of underperformance, you want to know whether asset allocation drove the outcome, or whether a high cash position due to a large gift receipt in the period created a drag on performance. Finally, don t forget that managers should be evaluated over longer time periods than a single quarter or year. Investment styles go in and out of favor depending on financial market conditions. Investment managers should be evaluated over a complete market cycle. 4

7 About the Authors Sally L. Rubin, CFA Director, Planned Giving Investments Sally Rubin is the director of investments for BNY Mellon Wealth Management s Planned Giving group. In this role, she oversees the overall investment process, including asset allocation and execution decisions, as well as the portfolio officers who are managing clients investment portfolios. Sally joined the firm in Previously she was with Frontier Capital Management for 12 years as a partner, co-portfolio manager and equity analyst. Before that, she worked as a business strategy consultant at Telesis, a Towers Perrin Company. Sally received a bachelor s degree from Harvard University and both a master s degree in music and a master of business administration from Yale University. She is also a CFA charterholder. Sally has 18 years of experience as a board member for non-profits such as the New England Conservatory of Music (NEC), Celebrity Series of Boston, Yellow Barn Music School and Festival and Emmanuel Music. At NEC she is past chair of the Board of Overseers, as well as a member of the Board of Trustees, Executive Committee, Investment Committee and Finance Committee. For the past nine years, Sally has been the sole outside trustee of a private foundation that supports cultural, environmental and public policy initiatives. Brandon Parrish, CFA Investment Officer Brandon is a portfolio manager for BNY Mellon Wealth Management s Planned Giving group. In this role, he works directly with clients to address their investment management needs. Brandon joined the firm in 2012 and has eight years of experience in the financial services industry. Prior to joining the firm, Brandon worked at State Street Corporation in their Global Markets division. Brandon received a bachelor s degree from Roger Williams University and a master s degree in finance from Boston College. Brandon is a CFA charterholder and a member of the Boston Security Analysis Society. 5

8 This material is provided for illustrative/educational purposes only. This material is not intended to constitute legal, tax, investment or financial advice. Effort has been made to ensure that the material presented herein is accurate at the time of publication. However, this material is not intended to be a full and exhaustive explanation of the law in any area or of all of the tax, investment or financial options available. The information discussed herein may not be applicable to or appropriate for every investor and should be used only after consultation with professionals who have reviewed your specific situation. BNY Mellon Wealth Management conducts business through various operating subsidiaries of The Bank of New York Mellon Corporation The Bank of New York Mellon Corporation. All rights reserved. 8/2014 [439]