By Gary Brent on June 18, 2015
How is your investment manager benchmarking the success of your portfolio?
This is a very important question, made all the more crucial because how your portfolio’s performance is judged – the benchmark against which it is being measured – can completely change the way your portfolio is structured.
Portfolio benchmarking is meant to answer one simple question: Has your portfolio been successful or not?
It is absolutely essential that the right benchmark is used to measure the success of your portfolio. But is the industry’s traditional approach of measuring successes against relative, market-based benchmarks effective?
I argue that it is not. In fact, the relative, market-based benchmarking practice can have a negative effect on clients’ ability to achieve their goals and produce positive outcomes.
Relative Benchmarking Doesn’t Work
Relative benchmarking against investment industry targets causes a complete disconnect with client goals.
Unfortunately, too many investment advisors and portfolio managers use this metric to convince clients that they’re doing a good job … even when they’re missing the mark for the clients’ needs.
Below, I outline two excellent examples that highlight how relative benchmarking fails:
Relative Benchmarking Can Deplete Capital
Let’s say your portfolio is structured to be compared to a relative benchmark.
A portfolio like this might be built with an over-emphasis on growth to allow your manager to outperform the benchmarks. You think your portfolio manager is doing a good job because year after year they come to you and tell you they’ve outperformed the benchmarks and your portfolio is succeeding.
It sounds like a good thing, doesn’t it?
Now consider that you have a capital base of $10 Million. Canada’s inflation rate for 2014 was roughly 1.5%. Therefore, your inflation adjusted capital base is $10.15 M.
Whether you are a high net worth family funding your lifestyle requirements or a foundation with funding obligations, you will have a certain amount of capital that you require each year. For this example, you have determined you require $350,000 per year.
So, you would need $10.5 M total to ensure you can meet your funding requirements and sustain your capital base for the year. Anything less and you will deplete your capital.
If the relative benchmark for the year is 2% and your investment manager achieves a 3% return for you, they will tell you your portfolio is doing well and that they are doing a good job.
However, with your 3% return, you will only have $10.3 M. Once you take out your living expenses or capital for funding obligations, you’re looking at $9.65 M – which is well below the inflation adjusted capital base of $10.15 M you needed to sustain your wealth.
Your investment manager has reduced your capital base to maintain their aggressively growth-structured portfolio. If this continues year over year, even though it looks successful on paper against the relative benchmarks, your long-term goals are at risk.
What’s Wrong Here?
Your policy is wrong relative to your goals. Your goals are your funding obligations, inflation protection, and long-term wealth sustainability.
But the portfolio is structured to beat relative benchmarks which have no bearing on these absolute goals.
You need a goals-based assessment. In my experience, I have seen that structuring a portfolio for goals rather than relative benchmarks can result in a vastly different outcome. In the case of this example, we’ve done analyses for clients where we have gone back and calculated what would have happened had their portfolios been structured differently – and they would have had a surplus rather than hitting up against their capital line.
So think twice the next time an investment manager tells you they’ve outperformed the S&P 500 for the past 30 years and that’s why you should hire them. You need to consider whether that is the right benchmark for you, and whether that performance will have the ability to generate cash flow to support your goals and funding requirements.
Benchmarking Against Peers Can Cause Essential Funding Targets to be Missed
Let’s say your portfolio is structured against another benchmark of your choosing. In this example, you want your portfolio to be benchmarked against your peer group.
If you’re a foundation, you may decide you want your portfolio to be on par with organizations of similar size and wealth. If you’re an affluent family, you may decide you want to outperform some group of well-known mutual funds, which somewhat replicates your portfolio.
With a portfolio structured against this type of benchmark, your manager may take money away from income-producing assets and put more money into other things, like hedge funds. Hedge funds are opaque and produce no income … but they have a chance of “hitting one out of the park”.
If your portfolio is structured like this, you face the danger of major risk exposure. If, and when, the market dips (or worse yet, crashes), you could lose a huge percentage of your assets.
That will mean you may not be able to meet your funding obligations in future years, and you will have to make cuts and changes.
Investing with a Purpose
Selecting the wrong benchmark changes the behaviour of your investment managers, as well as the architecture of your portfolio. It can result in disaster.
The question that needs to be at the center of your portfolio design is: What is the purpose of the money?
Ask yourself: Is the purpose of the money to keep up with peers? No. The purpose of the money is to meet your funding obligations.
With benchmarks based on your goals and funding needs, you might see less performance in some years – but you will meet your obligations and you will not expose yourself to the risk of losing an unacceptable amount in a bad year.
Why Investing Clients Need Goals-based Benchmarking
As you can see in the examples above, relative benchmarking is a bad metric for success for families and foundations with specific funding obligations. It’s simply not relevant to use index-based benchmarks.
Remember – your investment portfolio is just a utility. It’s only there to fund your goals in life and to ensure funds are available for future commitments and liabilities.
For example, do you want to leave a certain amount to your children? Do you want to buy a new place in Florida? How much do you need to maintain the lifestyle you want?
Your investment portfolio exists to help you achieve your goals within your timeframe. Therefore, your portfolio’s performance should be measured against your goals to determine its success.
It’s no wonder that clients whose investment managers are using relative benchmarks have begun to feel like they’re not being heard. When their goals aren’t met, investment managers rationalize performance and obscure the facts, until clients lose all confidence in them.
What the investment industry needs is transparency and goals-based benchmarking.
Don’t let investment managers force you into looking at your portfolio performance based on relative benchmarks. Although relative benchmarking may be appropriate for assessing each individual element of the portfolio, the performance of the portfolio as a whole needs to be about your absolute goals.
>> HighView is an experienced boutique investment counselling firm for affluent Canadian families and foundations. We would be happy to discuss our goals-based investment approach with you and your professional advisors.
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