The uses of benchmarks are frequently misunderstood and terms are often mixed up leading to widespread confusion. What therefore should charities consider?
Benchmarks are used for three main types of purpose. First, they can be used to set constraints on the types of asset and their proportions held in a portfolio. Second, they can be used to set targets to beat and third they are often used to provide a comparator of similar strategies or client types.
There are three main types of benchmark:
- Composite market indices – This typically combines a series of market indices in similar proportions to the portfolio’s long term strategic asset allocation. Assets held can be mapped to long term liabilities or required returns to help determine the long term risk/return objectives.
- Target return (also known as absolute return) – This measures portfolio progress against a fixed yardstick e.g. CPI plus 3%. It is important to remember that this is a longer term benchmark, most often used as a target to beat, and is less appropriate over short periods or in providing comparative data.
- Peer group – This looks at average performance of a group of charity funds e.g. ARC Charity Indices. This can be a useful sense check to see how your portfolio is performing compared to others. However, these benchmarks often do not consider the bespoke objectives of a charity and can group together portfolios with very different asset allocations and investment approaches.
Peer group benchmarks were the first type of benchmark to become popular. However, only return was considered, irrespective of the risk taken. This realisation often encouraged fund managers to take on more risk in a race to the top of the table. The result was that in the inevitable down-turn portfolios proved to be riskier than trustees were comfortable with.
Best practice led to the greater use of composite index benchmarks which looked like an ideal solution. However, trustees began to monitor achievement of their long-term objectives on increasingly short time frames. Unsophisticated clients tended to buy managers at the peak of their out-performance and then sell-out at their trough thus damaging investment returns. In turn, investment managers learnt that it was safer in terms of mandate retention to tightly (‘closet’) track the composite benchmark.
This in turn has led to the greater use of the target return benchmark. However, in the tenth year of the recovery after the financial crisis, there are lots of charities wondering whether they made the right decision to track CPI + 3%, when the performance of markets has averaged so much more.
Each of the three types of investment benchmark discussed captures desirable characteristics that trustees would want to encourage and monitor in a portfolio, however the focus on just one benchmark invariably leads to other desirable portfolio characteristics being neglected. As there is no single solution clients increasingly use a combination of all three types to reflect the uses to which each is best suited.
This approach helps provide a balance of desirable characteristics being monitored and encourages both the trustee and investment manager to pay close attention to all the characteristics. While this approach does not provide a hard and fast test of success and failure in the short term, it does help ensure that everyone is more focussed on what really matters through the whole investment cycle.
Nick Murphy, Head of Charities, Smith & Williamson
By necessity, this briefing can only provide a short overview and it is essential to seek professional advice before applying the contents of this article. This briefing does not constitute advice nor a recommendation relating to the acquisition or disposal of investments. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. Details correct at time of writing.
This article was previously published on Smith & Williamson prior to the launch of Evelyn Partners.