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In a break from the norm, I thought I would write about something other than the markets this time. The subject at hand is the important, but potentially confusing, matter of benchmarking.
So, what is it? Well, in investment terms, it is the practise of comparing metrics against markets, industry standards, or competitors in order to judge how well an investment is performing. Whilst this sounds straight forward enough, selection of appropriate benchmarks, the time period over which to judge performance and, indeed, the intention of the exercise can be tricky to get right. In fact, arguably, there is no “right” answer when it comes to these questions. We can only aim to arrive at the most appropriate decisions for our uses and point of view.
Investment and fund managers usually have a benchmark which is selected according to the asset class or mix of asset types which they are managing. For example, the manager of a UK equity fund may have the FTSE All Share as their benchmark. The manager of an Asia Pacific fund may have the MSCI Asia Pacific ex Japan index. In both these examples, reporting performance relative to these indices should give us a good idea of whether the fund manager is doing a good job by outperforming the market in which they operate, or not.
However, the selection of the index is critical as some may flatter relative performance. Below I have shown two perfectly reasonable passive (tracker) funds, the Vanguard Pacific ex Japan and the L&G Pacific Index. Both are low cost and track their benchmarks very closely indeed:
Despite, apparently, investing in the same asset class and region, the performance over the past 5 years has been vastly different. The reason behind the divergence is that L&G tracks an index which has a very different mix of countries, and therefore companies than the other. In fact, the Vanguard fund has over double the exposure to Australia, at 61%, than L&G. Clearly then, clients and investment manager alike need to be extremely careful over which index they choose as their benchmark.
It is important to say that benchmarking in this way has some very important benefits when analysing the relative performance of a fund or portfolio. They key benefit is the ability to easily ascertain whether the manager’s decisions have added value or not, a process know as attribution analysis.
Sticking with our example of an Asian equity fund, benchmarking versus an appropriate index allows us to know the country, sector/industry and company allocation of the benchmark. Therefore, we can calculate whether the manager’s decision to be overweight or underweight in any of these has added to, or detracted from, relative returns. Whilst potentially time consuming, this is a beneficial exercise as it can give an indication of the manager’s skill.
Whilst benchmarking versus and index, or mix of indices, can show us the value added by the fund manager over the underlying market(s) and indicate their decision-making prowess, it tells us nothing about how they are performing versus their peers.
As per usual, there is a multitude of ways of doing this but, for the sake of brevity, I will focus on the main ones for now.
For funds investing in a single asset class, we can benchmark against the appropriate sector, which shows the average performance for funds of a similar type. For example, a UK Equity fund may be benchmarked against the IA All Companies sector.
However, things get a bit more complicated when we are analysing funds, or portfolios, which invest across several asset classes. For multi-asset funds, the easiest way of seeing how well they are doing versus the competition is to compare them to a “mixed” sector. In the example below, I have shown the performance of the IFSL Avellemy 5 fund against the IA Mixed 20-60% Shares sector:
We can see that the fund has done well versus the benchmark since it’s inception in 2019.
But we do need to take care here. The sector, as the name suggests, allows for anywhere between 20% and 60% of a member fund to be invested in equities. Clearly, the size of a funds allocation to equities could have a material impact on its relative performance and this could be either positive or negative, depending on the direction of equity markets at the time of analysis.
When looking at portfolios, especially tailored portfolios managed on a discretionary basis, the challenge becomes greater because, at least in theory, no two portfolios should be the same. To combat this, a few providers have constructed “private client indices”, the most well-known being ARC and PIMFA. These perform an identical function to the IA mixed sectors. They aggregate performance data from discretionary fund managers and deliver an average performance in the form of an index. However, the same pitfall arises in that they allow for a wide range of allocation to equities. Therefore, the asset allocation adopted by your fund manager can have a meaningful impact on performance relative to their peers.
If one fund or investment manager is performing better than the average of the competition, why do we care whether this is down to their asset allocation or not? This brings me to another, in our opinion, critical function of benchmarking, risk.
Nowadays, clients who have been guided by a financial adviser will have invariably completed an attitude to risk questionnaire before, with the help of their adviser, selecting a fund, portfolio or service, suitable for the given risk profile.
As I have eluded to above, commonly accepted ways of benchmarking versus the competition gives us absolutely no idea whether the chosen vehicle is delivering an attractive return for our chosen level of risk, or whether the manager is keeping within reasonable risk tolerances. After all, with wide allowable equity allocation ranges, the actual risk for a given investment could vary significantly within the sector or peer group.
Only benchmarking versus an appropriately asset allocated basket of indices, known as a composite benchmark, will allow us to do this. However, the construction of these can be time consuming and confusing.
We live in a heavily regulated world where investment performance reporting is subject to strict rules around regularity, particularly for discretionary managed services.
For this type of service, the investment manager is obliged to report their performance quarterly. We would argue that this encourages short-term thinking and that performance should be judged over much longer timeframes, but rules are rules nonetheless.
When selecting funds on behalf of clients, our internal process analyses performance over at least 3 years, 5 years if two are very similar. This is because looking at a shorter timeframes doesn’t give us a clear picture. In the charts below, I have shown the Royal London Sustainable Leaders Trust versus its competitors, the IA UK All Companies sector, over one year:
This shows underperformance of over 8%, but does this mean that is it a poor fund to be avoided? Let’s look at 3 and 5 years:
What a difference! Regular readers will know that we firmly believe in the benefits of long term thinking and the focus on risk adjusted returns.
I am acutely aware that readers may, by this point, be thoroughly confused. I would like to reiterate my earlier remarks, there is no right answer.
However, here are some suggestions which I hope are helpful:
Until next time, stay well.
Past performance is not a guide to future performance and may not be repeated. Investment involves risk.
The value of investments and the income from them may go down as well as up and investors may not get back any of the amount originally invested. Because of this, an investor is not certain to make a profit on an investment and may lose money. Exchange rate changes may cause the value of overseas investments to rise or fall.
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