Thoughts on BENCHMARKING

Transcription

1 Thoughts on BENCHMARKING Why delve into all of this detailed material? Because one aspect of SIMI s business policy calls for us to enlighten our clients, causing them to be be er educated investors. INTRODUCTION In the investment field, a benchmark por olio is a structured index por olio of securi es created by a benchmark provider that is generally representa ve of a par cular investment market. The S&P 500 Index, for example, is considered to be a benchmark for the U.S. stock market. Its informa on value to an investor is in being a convenient way to glean an understanding of how the en re U.S. stock market is generally performing through the lens of a single index number. Since we are balanced managers for you, owning a combina on of stocks, bonds, cash, commodity funds, etc., we now have a specific benchmark index por olio for each asset class which, in combina on, creates your Policy Benchmark. Por olio managers generate account performance which typically fluctuates around their selected benchmarks, some mes bea ng it and other mes underperforming it. From a long term perspec ve of say, greater than five years, the odds of bea ng any benchmark on a cumula ve basis con nue to diminish as the compounding effects of trading costs, administra ve fees, and account management fees take an ever rising toll on rela ve performance. This is the case because benchmark indices themselves have no trading costs or opera ng expenses. So, if long term ac ve management outperformance rela ve to a benchmark is pre y much a non starter, it is reasonable to ask how one should determine if a manager s performance falls within acceptable boundaries of investment return. We ll tackle that topic in Part II of our benchmarking discussion in our next quarterly report. For the balance of this report, our inten on is to introduce the various features of benchmarks and to present several thoughts regarding the benefits and limita ons of por olio benchmarking. BACKGROUND There s an understandable expecta on among many investors that a por olio manager s job is to beat his or her benchmark over some agreed upon period of me. This may be a reasonable assump on if one were simply selec ng an ac vely managed mutual fund whose performance objec ve is defined rela ve to a par cular benchmark index. A er all, an investor could simply purchase an index fund if all they wanted is index fund performance (less fees). But, by making the decision instead to employ an ac vely managed approach, one s expecta on could be to earn a return greater than the associated benchmark index. Otherwise why incur a fee for ac ve por olio management? Please read on! In contrast to this line of reasoning, we want to dispel any no on that SIMI s purpose in managing client por olios is simply to beat the benchmark index for each of your asset classes. We don t manage por olios in a manner which a empts to beat any benchmark. It s not our mandate in our clients Investment Policy Statement (IPS). Our mandate is instead, to help each client achieve long term individual investment objec ves. Por olios simply aren t constructed or managed to be in a foot race with any benchmark index. While it is true that por olios are structured to be generally representa ve of each selected benchmark, we incorporate many specific traits or lts to these por olios which serve to disqualify many of the securi es contained in the benchmark index. Of course, we hope that our customizing ac ons will lead to por olio rela ve outperformance, but markets don t always cooperate. 1

2 BENCHMARKING (Con nued) STOCKS/EQUITIES Consider the following regarding benchmark stock market indices: 1. The major stock market indices are typically constructed on a capitaliza on weighted basis, meaning that the largest companies by total market value comprise the largest percentages of the index. Client por olios, however, are constructed on a more or less equal weighted basis and contain a very small percentage of the stocks found in the benchmark index. Furthermore, we are not constrained to owning only those securi es contained in our equity benchmark. 2. Indices have no guidelines as to how large individual posi ons can grow in a momentum driven market. We, on the other hand, in the interest of prudence, will trim back a security posi on the more overvalued (in our opinion) the security becomes or the more dispropor onate it becomes rela ve to clients other investments. This means we may be cu ng short the remaining upside of a rapidly rising security simply because our concept of valua on is being violated. We take this ac on because a dispropor onately large security posi on in a client s por olio may eventually create a very uncomfortable level of vola lity in investment returns. In the benchmark index however, the same security will have negligible impact on vola lity, being just one small component within a substan ally greater number of securi es. 3. Indices will typically contain many securi es which, for a variety of reasons, we deem to be inappropriate, or even imprudent, for our clients. Many factors come into play here: Company size, company leverage (amount of debt to equity), dividend policy and management s ability to add shareholder value, to name but a few. Nevertheless, from me to me, companies which don t meet our investment criteria may significantly outperform the rest of the market, adding dispropor onately to benchmark index return. 4. Equity indices represent more or less sta c por olios of securi es; there s not a lot of turnover per year. The securi es in the S&P 500 Index aren t adjusted, if for example, Greece is expected to exit the Euro Zone with seriously nega ve contagion consequences to the global banking system. Our clients, on the other hand, rightly expect that we shouldn t poten ally jeopardize the value of their por olios if the Greek situa on doesn t have a favorable outcome. Indices are infinite lived vehicles; our clients, unfortunately, are not. So, we take posi ons of a defensive or offensive manner in client por olios regarding situa ons which may or may not materialize, and which indices ignore. Then we adjust por olio holdings as subsequent events prove our various assump ons either correct or incorrect. 5. Since we are global equity managers, we have chosen the MSCI All World Index to be the benchmark for the equity por on of your por olio. As a result, addi onal influences beyond individual company performance influence index performance. Principal among these are currency influences, country economics, and poli cal influences. In sum, the number of indexinfluencing variables on a global equity index defy the calcula ng power of today s most advanced computers to accurately model all future outcomes and associated probabili es. BONDS/FIXED INCOME On the fixed income side there are addi onal issues for investors to ponder. The most common characteris c of bond indices or benchmarks is the fact that their composi on is constantly changing as older bonds mature or are redeemed early and newer ones are added. This has an impact on the benchmark s average yield to maturity, coupon rate, and average credit ra ng, in addi on to other more technical characteris cs. Industry composi on among the holdings ebbs and flows. In the case of our fixed income benchmark, the U.S. Investment Grade Corporate Bond Index, bonds may enter or leave the index as their credit ra ngs change. The index thus takes on the characteris cs of a moving 2

3 target over me. We on the other hand, wouldn t sell a bond from a client por olio due to a ra ngs change unless we concluded that return of principal at maturity of the issuer has been jeopardized. We also select an approximate average maturity range for bond por olios that we deem appropriate for our clients, but that may differ from that of the index. OTHER CONSIDERATIONS From a philosophical standpoint, the price ac on of any securi es market and therefore the benchmark index designed to capture that price ac on reflects the extraordinarily varied interests of all the par cipants in that market each day. There are those who, for example, are momentum based day traders. They couldn t care less about earnings quality, long term corporate objec ves, dividend yields, etc. Their investment me horizon can be as short as microseconds; perhaps as long as a day. We men on this point because today, very short term trading represents a significant percentage of daily stock market volume, but the resul ng security price movements from this con ngent of stock market par cipants simply isn t relevant to SIMI s clients. On May 6, 2010 for example, the Dow Jones Industrial Average experienced a 1,000 point flash crash in which computer generated trading engineered a rapid downturn in prices followed by an almost as rapid price recovery. This vola lity might have been a day trader s dream (or nightmare), but from the standpoint of our clients it was a non relevant occurrence. Humans are not computers. People are burdened with all kinds of biases which interfere with ra onal, objec ve behavior. Other market par cipants may have investment meframes of weeks or months while our me frame as defined in each client s IPS, is in terms of years. The point here is that in spite of drama cally different goals, objec ves, meframes, etc.; we all enter the same marketplace to actualize our vastly differing investment objec ves. The performance ac ons of our benchmarks are clearly influenced by factors having nothing to do with our personal investment objec ves. Therefore, in the short term of a calendar quarter or even a year, a comparison of the performance of a client s por olio rela ve to a benchmark may have li le or no valuable informa on content. Our industry generally acknowledges that a 3 5 year meframe is a more appropriate me period against which manager performance should be measured and compared to appropriate benchmark indices. Such a meframe allows for shorter term influences to dissipate out of performance results. One final observa on about opera ng costs bears men oning. Indices operate in an almost fric onfree environment. By this we mean there are no trading costs, no advisory fees and no penal es for illiquidity regarding thinly traded securi es. Ac ve managers, on the other hand, incur all of these trading costs, and more. It is the compounding of these costs which makes it increasingly difficult to outperform any benchmark with the passage of me. It s true that, from me to me, lucky bets by a por olio manager in as li le as one me period (one quarter, for example) may result in significant outperformance rela ve to a benchmark that carries forward in return calcula ons for some number of future me periods on a cumula ve basis, perhaps as long as a few years. But, just like the inexorable pull of gravity on objects opera ng in the earth s atmosphere, eventually the compounding costs of ac ve por olio management pull manager performance down to levels below that of their benchmarks. A hypothe cal illustra on of the one me verses cumula ve me period effect will clarify this point (See EXHIBIT 1 The Curious case of the outperforming, underperforming por olio manager). As a result of these items, as well as others which if listed would cause this piece to be en rely too long, the insight into benchmarking which we seek to impress upon our reader is this: Asset class benchmarks are simply guideposts around which clients respec ve asset classes should perform within a reasonable proximity. The sta c structure of an equity benchmark allows the client and manager to discuss the reasons for differences in performance and allows for insights into the manager s investment decision making process. It can then be demonstrated that rela ve outperformance doesn t necessarily imply an extraordinary manager skillset, nor does underperformance imply a sudden loss of manager capability. 3

4 BENCHMARKING (Con nued) EXHIBIT 1 The curious case of the outperforming, underperforming por olio manager. In the chart above our hypothe cal money manager significantly outperformed the benchmark index in year one. Therea er, in each of the years 2 10, the manager underperformed the benchmark. The manager s first year outperformance was of such significance however, that on a cumula ve basis the manager could correctly claim to have outperformed the index each year un l the end of the eighth year when the cumula ve index return finally pulled ahead of the manager s cumula ve numbers. For this manager to tout his market bea ng cumula ve performance during years two through seven might be great for marke ng purposes. But not one single client who signed up a er year one results were announced would receive market bea ng returns. Finally, it is highly unlikely that the bet the manager made in year one that worked out so well is a repeatable event. Every investor should always remember the well worn phrase: Past performance is not indica ve of future returns. Fair ques ons at this point are If ac ve managers can t regularly outperform their benchmarks why bother with ac ve management at all? Why should I not just buy index funds and forget about trying to pick managers if the odds are that they can t be expected to beat their benchmarks? And, as asked at the beginning of this piece, Why pay ac ve management fees for likely long term underperformance rela ve to indices? The field of behavioral finance gives us the answers: Humans are not computers. People are burdened with all kinds of biases which interfere with ra onal, objec ve behavior. Examples of o en repeated harmful investor ac vity include panic selling at market bo oms or stampeding in at market tops. Overconfidence and linear thinking (recent events will con nue into the future) are also near the top of the list of biases. Our investment literature has documented ad nauseum the truly shocking rates of investor under performance rela ve to both index funds and managed investment products when individuals manage their own por olios. Simply put, we as individuals are not biologically wired to react correctly to erra c and vola le market behavior. Skilled and experienced por olio managers, on the other hand, are at least equipped with a sense of perspec ve that may enable them to guide clients through the emo onal extremes which investment markets evoke. 4

5 Finally, a reader may ask, why bother with benchmarks at all? The most basic reason is that the crea on of any por olio needs some frame of reference for a star ng point, and industry best prac ces as well as fiduciary obliga ons call for diversifica on as a risk control measure. Thus investors or their money managers need some type of a framework upon which a por olio can be built, con nuously managed, and compared to on a performance basis. Hence the need for a benchmark. Please consider that SIMI is managing its clients money pursuant to their investment philosophy as set forth in Investment Policy Statements that explain how they expect ac ve management to add value to their por olio. In this sense the client as the investor should feel comfortable with each asset class benchmark. Their composi on and characteris cs should be in alignment with clients investment objec ves. SIMI, as its clients investment manager, makes ac ve decisions regarding which securi es and risk factors to over/underweight in order to generate ac ve returns rela ve to benchmark indices. These ac ve decisions can then be analyzed with the benefit of hindsight to determine if value has in fact been added. Periodic comparison to the performance of the benchmark gives us a feedback mechanism with informa on that allows for con nuing refinement of our investment process via à vis your needs and objec ves. In many cases, value includes an intangible and immeasurable element: The relief that comes with knowing that the investment professional is providing a service in a complex and o en overwhelming market environment. CONCLUDING THOUGHTS A benchmark is a structured investment product represen ng a por olio of securi es with which you are comfortable regarding its longer term general risk and reward characteris cs rela ve to your investment objec ves; Asset class benchmarks are simply guideposts around which clients rela ve asset classes should perform within a reasonable proximity. A benchmark is simply a star ng point in por olio construc on; A benchmark is not completely investable fine tuning is required; No money manager can control future returns, i.e. there is no crystal ball. Por olio risk, however, can be managed to your own comfort level through an asset alloca on framework as described in your Investment Policy Statement. Clients assign tac cal asset alloca on decisions within that framework to SIMI; While we don t invest clients money with the goal of simply bea ng the benchmark index, we can t deny that each selected benchmark exerts some degree of pull on our security selec on and management process; Given the significant degree of construc on differences between benchmark indices and clients actual por olios, por olio rela ve performance will fall within a range above and below those indices. Roger A. Sheffield, CFA Sheffield Investment Management, Inc. 900 Circle 75 Parkway, Suite 750 Atlanta, GA (770) (770) (fax) 5