Sustainability: “Skill vs. Luck”

Fall 2007 CSANews Issue 64  |  Posted date : Oct 17, 2007.Back to list

A few months ago, I was discussing last year’s equity returns with a good friend of mine and he mentioned that his advisor did quite well, having returned 14%. Unfortunately, the corresponding index returned 18% over the same period. The various equity market indexes are measures of what returns were available to investors in the markets. Nowadays, with low-cost ETFs (Exchange Traded Funds), investors can reap the benefits of the available returns within a few tenths of a per cent of what the markets offer. How do you know that you are getting a fair share of the returns offered by the markets?

If you read on, you will find out:

What’s a benchmark?
Why are benchmarks important?

How can you use them to evaluate your portfolio’s, fund’s or advisor’s performance?

So, what is a benchmark? One of the areas usually overlooked by investors is a valid measure of a portfolio, fund/manager or advisor performance. And as soon as you say performance, you must next ask the question “performance relative to what?” One of the Merriam-Webster definitions of a benchmark is “something that serves as a standard by which others may be measured or judged.”

In investment management, a benchmark must have certain properties. Some of these properties include being unambiguous (i.e. you know what the ingredients are and how much of each to use), investable (i.e. you can buy and hold the benchmark), and the appropriateness of the measure (i.e. you don’t measure the performance of small cap fund against the large cap index).

As to the type of benchmark, while there are many, to keep it simple we’ll focus on broad market indexes as benchmarks. Examples of commonly used U.S. indexes that can be used as benchmarks are S&P500 (500 stocks representative of the large cap U.S. stock market), Wilshire5000 (more than 5,000 stocks representative of the total U.S. stock market) for U.S. equity or Lehman Aggregate Bond Index (representative of the U.S. bond market) for U.S. bond funds. For Canadian capital markets, good benchmarks are the S&P/TSX60 Index (60 stocks representative of Canadian large cap market) for stocks and Scotia Capital Universe Bond Index (representative of Canadian bonds with maturity longer than one year). The MSCI EAFE Developed Market Index is representative of the stock markets of more than 20 developed countries, excluding U.S. and Canada.

For an investor’s portfolio, one may use a weighted combination of the above benchmarks in a manner that is representative of one’s target asset allocation.

Why are benchmarks important? For portfolios, goodness of performance is measured relative to some benchmark. So your assessment of performance of your Canadian or U.S. stock portfolio, which returned 10% last year, may be “good”, “bad” or “so-so,” depending on whether the TSX/60 or S&P500 return was 3%, 15% or around 10%.

Another useful measure of goodness, though not a benchmark in the strict sense (as it doesn’t have some of the required properties mentioned earlier), is when an investor compares the achieved returns over the past year to some absolute target. An example of a target may be inflation plus the required withdrawal from the portfolio to maintain a given lifestyle. If the portfolio return exceeds the sum of the rate of inflation plus withdrawal rate, then the residual portfolio’s buying power will have increased over the past year; otherwise, the buying power of the remaining portfolio will have decreased.

Of course, in addition to market returns, the costs incurred by the investors will determine what their net returns will actually be. The costs come in many shapes and forms such as management expenses (MERs), trading costs, taxes, etc. Active managers try to beat the market, but there are a number of problems with this; it is very difficult for a manager to beat the market on a sustained basis and, while we know which managers beat the market last year, it is difficult to know who will do so next year. If mutual fund fees are 2-3% or so per year (as they typically are in Canada), then the fund manager must outperform the index by that 2-3% year after year, just to overcome the management fees; not a cakewalk! So we don’t know what the market returns will be next year and we don’t know who will beat them; the only thing about which we are certain is that we will incur costs when buying and holding securities, and those costs will be deducted from the returns offered by the markets.

Whether we choose to use mutual funds or just build our portfolio from stocks, we have to measure how well we have done relative to what the market offers.

How to use benchmarks to evaluate your portfolio’s, fund’s or advisor’s performance?

For a mutual fund manager of large cap U.S. equities, one may use S&P500 as a benchmark against which to measure relative performance; however, for a Canadian large cap equity fund manager, the S&P/TSX60 Index would be more appropriate. Similarly, one could define an overall portfolio benchmark for an investor whose target asset allocation is 50% stocks and 50% bonds, participating in the Canadian market only, to be the return of (0.5 x S&P/TSX60 + 0.5 x Scotia Capital Universe Bond) indexes. One could do the same with a specified proportion of U.S. and international equity content in the portfolio.

A caveat when using indexes is to make sure that you compare apples to apples, as indexes are available in various flavours such as ‘Total Return’ including dividends or ‘Price Series’ without dividends. When looking at indexes associated with non-Canadian markets, the indexes may be in local currency or in U.S. dollars or may even be available hedged into Canadian dollars.

Another example of a benchmark is the one used by the CPP Investment Board. They indicate that “The current composition of the Reference Portfolio benchmark is 40 per cent foreign equities, 25 per cent Canadian equities, 25 per cent Canadian fixed income and 10 per cent Canadian real return bonds.” They specifically state that the actual portfolio composition is not driven by that benchmark; however, they are using that benchmark as the hurdle which they are striving to exceed. The CPP Investment Board must feel that the risk characteristics of the CPP portfolio are also representative of the benchmark.

The measure of risk is usually volatility of returns. (For those of us who may have forgotten the meaning of risk/volatility, we certainly got a reminder of it in mid-August, as I am writing this). While we won’t discuss risk in detail here, higher returns for individual assets are typically accompanied by higher risk. The challenge in portfolio asset allocation is to maximize return for some tolerable level of risk by combining a number of assets, each having different characteristics. However, as an investor in a fund, one must ensure that the fund manager did not achieve a (short-term and unlikely to be sustained) better performance by taking on excessive risk relative to the appropriate benchmark, or risk inconsistent with the intent of the fund!

You may get various index performance figures on which to base your benchmarks from your broker or, for example, at Barclays iShares' Canadian website where, by the way, the international indexes reported are hedged to Canadian dollars (just like Barclays’s international ETF offerings in Canada). If you were invested in an unhedged version of an international index, its impact on your portfolio would be determined not just by the return, but also by the exchange rate movement.

So if you have not yet selected benchmarks for your funds and/or your portfolio, you should select appropriate ones (or ask your advisor to define and explain his selections) and periodically review performance against those selected. How else will you know how your fund/portfolio/advisor is doing and that you are getting a fair share of the returns available in the markets?




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