BENCHMARKS TOPIC SUMMARY Scott Adams, Dilbert BENCHMARKS The - - PowerPoint PPT Presentation

BENCHMARKS

Scott Adams, Dilbert

TOPIC SUMMARY

BENCHMARKS

The Investment Process and how BM fits BM definition and why is it important? Uses for BMs Different types Who are the relevant parties? Properties of Ideal BM Examples Problems in BM selection Points to Ponder

INVESTMENT PROCESS

Investment Policy

• Investment Philosophy
• Goals/Objectives
• Benchmarks/Targets
• Risk tolerance
• Horizon
• SRI

Manager Selection/ Retention

• Mandate design/development
• Determine Risk Exposures, weightings
• Asset allocation decisions?
• Manager Strategies
• Optimal Risk/Reward allocation and weightings

Manager Portfolio Management

• Implementation of portfolio strategy/mandate
• Portfolio construction
• Asset allocation
• Security selection
• Optimization
• Implementation
• Execution
• Ongoing monitoring and revision against markets
• Performance measurement, attribution, appraisal
• Reassess tools, strategy, data, decision-making

Performance Evaluation

• Performance Measurement
• Attribution analysis
• Appraisal – skill or luck?
• BM comparisons
• Reassess tools, strategy, data, decision-making

MANAGER PERFORMANCE REVIEW

Performance Measurement Manager Selection/Retention

Measurement of performance and risk Ex post / ex ante Risk – Absolute and Relative Above or Below BM? Hire/Fire/Retain Quantitative and qualitative analysis Costs

COMPREHENSIVE PERFORMANCE EVALUATION

Performance Measurement Performance Attribution Performance Appraisal Manager Selection/Retention

Measurement of performance and risk Ex post / ex ante Risk – Absolute and Relative

Identifying and quantifying the sources of performance of a portfolio Across investment decisions from number of perspectives, asset class and intra asset class. Look at Return and Risk attribution:

• Return: ID sources of excess return (Portfolio – BM) – ex post
• Risk: ID sources of investment risk + impact of decisions contributing to total risk – ex

ante + ex post

ID and Measuring of investment skill Treats returns in conjunction with risk – were returns sufficient compensation for the risks taken? Hire/Fire/Retain Quantitative and qualitative analysis Costs

BM Critical Processes

THE FOUNDATION

• Investment Philosophy
• Goals/Objectives
• Risk tolerance
• Horizon
• SRI

BENCHMARK

THE INVESTMENT POLICY STATEMENT

DEFINITION OF BENCHMARK

Merriam Webster: “… a : a point of reference from which measurements may be made

b : something that serves as a standard by which others may be measured or judged - a stock whose performance is a benchmark against which other stocks can be measured…”

“Origin: The term bench mark, or benchmark, originates from the chiselled horizontal marks that surveyors made in stone structures, into which an angle-iron could be placed to form a "bench" for a levelling rod, thus ensuring that a levelling rod could be accurately repositioned in the same place in the future.” (https://en.wikipedia.org/wiki/Benchmark_(surveying) ) Concise Oxford Dictionary: “ n. 1. a standard or point of reference against which things may be compared or assessed”

WHY IS BM CHOICE IMPORTANT?

• “client bears the benchmark risk and the active manager bears the active risk of

deviating from the benchmark” Grinold and Khan (Active Portfolio Management, 1995)

• When manager and client identify and agree the BM they identify the general risk-

return characteristics that client will expect over time.

• Portfolio attribution – skill/luck? – how many calls paid off/ not
• Assists with the identification of the sources of risk and return in the portfolio
• Clarifies and highlights accurate risk management/controls
• Alignment in manager and investor’s evaluation of performance
• Transparent selection process and expectations

USES OF BM

• Reference point for portfolio or segments of portfolio
• Neutral comparison point measuring progress to investment goals
• Communication of need/instructions to manager
• Conveys investor/sponsor’s expectations of how funds will be invested and the portfolio’s risk and return profile to the manager
• Communication with trustees/board of directors
• Manager’s expertise and the subsequent investment and evaluation
• ID and evaluation of current portfolio’s risk exposures
• Should be similar to manager’s risk exposures and therefore provide guidance in this regard
• Interpretation of past performance and attribution
• Determine and evaluate excess return - whether manager’s decisions have added value
• Main focus to distinguish luck from skill
• Inappropriate BM provides noise and misleads, while accurate BM enhances effectiveness of manager assessment.
• Manager selection and appraisal
• Influence the perception of manager skill.
• Other (Marketing and Compliance)

TYPES OF BENCHMARKS

DEPENDS ON MANDATE/STRATEGY

• Market Index – Dow Jones Industrial Average, S&P 500, JSE ALSI Total Return
• Sub set - Style indexes – Growth and Value indexes
• ETF – Investible versions/vehicles of above market indexes, iShares Dow Jones ETF (IYY), iShares S&P500

UCITS ETF (IUSA), Satrix Top 40

• Peer groups/Universe – HFRI, Credit Suisse/Tremont, ASISA Fund Category or ARC Private Client Index
• Absolute return – 9% pa, Cash Plus 3% or CPI plus 5%
• Factor model based benchmark – simplest form – single factor- return on broad market index, add

more sensitivity to eg interest rates, credit extension, inflation

• Returns based benchmarks – eg Sharpe Style analysis – similar to factor based benchmarks, but returns
• n various style indexes
• Custom benchmarks – Constructed specifically from the likely refined universe to be selected from and/or

the investment process of the manager (eg Asset Allocation)

WHICH LEVEL BM APPROPRIATE AND WHAT BM

Where investment decisions are made:

• 1. Sponsor level – Trustee, advisor, investor

Asset Allocation, CPI +

• 2. Portfolio Manager – Asset Allocator

Asset Allocation

• 3. Portfolio Manager – Direct manager

Equity, bond, asset class specific Investor/Trustee Manager

Equity Fund

Manager - AA

Bond Fund Property Fund

Alternatives Fund

Equity Bonds Property Cash

Alternatives

1. 2. 3. 3.

PROPERTIES OF IDEAL BENCHMARK

BAILEY AND TIERNEY (1998)

1. Unambiguous 2. Investible 3. Measurable 4. Appropriate 5. Reflective of current views – does the manager have an opinion on components 6. Specified in advance 7. Accountable

• Consistent with manager process
• Must be able to display validity of own BM

PROBLEMS WITH BM SELECTION

• Peer groups – no incentive to outperform the median possibly results in herding behavior
• Manager driven BM swapping to make comparisons more attractive (unethical)
• Ratios and risks calculated with inappropriate BM will be meaningless or misleading (eg

information ratio, tracking risk etc)

• Provide incorrect assessment of performance and attribution analysis will not be useful:
• If “Normal/Neutral’ Portfolio is used as BM, then an inappropriate BM leads to incorrect performance measurement:
• Manager’s “True” Active Return = Manager’s Return – Manager’s Normal Portfolio Return
• Manager’s “Misfit” Active Return = Manager’s Normal Portfolio Return – Investor’s BM Return
• Affects performance fees and the calculation thereof
• Potentially also creates more risk, as incorrect benchmark may incentivize manager to take more

risks to achieve inappropriate benchmark.

• Leverage in portfolio – is this reflected in the BM?
• Currencies, to hedge or not to hedge and how apply in BM
• SRI – negative screening for unwanted holdings

EXAMPLES*

• Satrix ALSI ETF
• potentially meets all the requirements for a South African equity manager
• iShares MSCI AC World Index (ACWI)
• potentially meets most requirements for Global Equity Manager, although constituents an issue
• Peer Groups - fails on most of the 7 properties for an appropriate BM
• ASISA South Africa Equity General
• ARC Sterling Balanced Asset PCI
• Absolute Return BM - fails on most of the 7 properties for an appropriate BM
• CPI + 4%, cash plus 3%, 9% per annum
• However, reference manager strategy for most appropriate BM

* This is not advice

EXAMPLE – ALLAN GRAY*

ASISA Classification (approved by Board 7 March 2017):

Equity – General portfolios - These portfolios invest in selected shares across all industry groups as well as across the range of large, mid and smaller market capitalisation shares. While the managers of these portfolios may subscribe to different investment styles or approaches, their intent is to produce a risk/return profile that is comparable with the risk/return profile of the overall JSE equities

• market. The portfolios in this category offer medium to long-term capital growth as their primary investment objective.

SA Benchmark: FTSE/JSE All Share index (J203T) * This is not advice

EXAMPLE – CORONATION*

• Benchmark:
• Composite
• 52.5% equity
• 22.5% bonds
• 20% international
• 5% cash
• Components?
• Neutral weights

* This is not advice

EXAMPLE – FOORD GLOBAL EQUITY FEEDER FUND*

• Understanding BM and component allocation con stimulate meaningful dialog with manager on returns
• Able to better assess whether a change needs to be made
• Transparency always preferred

* This is not advice

POINTS TO PONDER

• What does this all mean for fiduciary responsibility as it can get complex and therefore

expensive?

• Firstly – the Investment Policy Statement
• Ensure accuracy of parameters and that BM matches these parameters
• Review parameters at least annually
• If have resources – Get specialist to help design/determine BM fit and to review

performance of manager

• If not, put some effort into assessing a BM:

 Query manager on BM and appropriateness, construction thereof etc to get a sense whether components appropriately fit the composition of the portfolio  Understand the manager’s processes and neutral positions  Verify that manager is measured over appropriate corresponding periods using the BM and Portfolio  Understand manager differences from the BM

POINTS TO PONDER – CONTINUED

• Trustee, Investment Advisor and/or Investment Manager in same group
• Additional burden to ensure independence not affected
• IPS
• Interrogate BM against IPS and the Properties of an Appropriate BM:
• Unambiguous
• Investible
• Measurable
• Appropriate
• Reflective of current views – does the manager have an opinion on components
• Specified in advance
• Accountable
• Understand the variances of performance against the BM
• If consistently underperform, need to change… well chosen and agreed BM makes

this easier

THE END

CREDITS:

CIPM Program Principles Volume 1, 2016 CIPM Program Expert Volume 1, 2017 Grinold and Khan (Active Portfolio Management, 1995)