Benchmarking in the DFM world

25 July 2016

Fraser Donaldson – Insight Analyst (Investments)

A benchmark is set for portfolios in order to establish a baseline against which portfolio performance is measured. There are two parties that rely on this information. Firstly, the client who uses the benchmark as a frame of reference against which they can judge how the portfolio is doing.

Investment managers are also interested in how their portfolios are doing as they may be being rewarded for outperforming a set benchmark.

Funds will tend to have two benchmarks. The first is often the sector average, the second usually an index or composite of several indices relating to similar funds. For example, a UK equity fund may have a sector average benchmark such as the IA (Investment Association) UK All companies sector and an index benchmark such as the FTSE All Share Index. When performance charts are produced for clients, it will usually be against these kind of benchmarks.

In the DFM world, there are no sector averages and it is often difficult to identify similar portfolio types.

With bespoke portfolios, those that are structured for the individual client, the benchmarks used to monitor performance are set in discussion between the portfolio manager and the client (and/or his adviser). In this respect, the benchmarks ought to be relevant and meaningful to the individual client.

With Managed Portfolio Services where all clients of a similar type get the same portfolio, benchmarks tend to be set in a similar way to funds, with absolute returns being the guiding influence. Most portfolios can be described as multi-asset, so portfolios tend to have composite indices as benchmarks.

Where outperformance is what is being paid for this is still a valid method. However, most clients are not looking to ‘shoot the lights out’, showing top quartile performance over some arbitrary period. We have seen a mind-set change over the last 5 years or so where advisers now see investment success as delivering expected client outcomes (performance if you like), but crucially at a risk level that the client is comfortable with.  Often, those funds or portfolios that are topping the performance charts over relatively short periods of time could well be taking excessive risk, and this is difficult to maintain.

Performance, and yes there does need to be some, is not the only measure of success. Performance should always be accompanied by a measure of risk taken, perhaps volatility. The two taken together give a much more informed picture of progress.

Clients that have a bespoke portfolio, should be clear about the risk they are prepared to take and insist that some measure of this is used as one of the benchmarks. The second benchmark should probably be some measure of ‘cash plus’ that reflects the outcome that the client is expecting (perhaps cash plus RPI, CPI or just a percentage).

We all know that portfolio value can rise and fall, so the measure needs to be taken over a reasonable time period, say 5 years where market cycles have time to play out. Of course, there are always a few clients that are risk takers and want to beat the market, peers and probably their neighbours. For them traditional performance benchmarks are fine.

With MPS portfolios, there may be an element of DIY benchmarking required. There are plenty of tools out there that will risk rate a portfolio. This is fine for those portfolios that are risk targeted, in other words you can be reasonably sure that the manager will stick within a volatility band. This is usually published and therefore relatively easily to check. Couple this with some appropriate performance measures and job done. Although, it would be wise to check that the manager is sticking to the risk band.

There are, however, just as many risk focused funds and portfolios as there are risk targeted. This means that the management of risk is still a priority, but the manager does not need to stay within set risk bands. If he feels there is momentum in the market he can dial up the risk, and if he feels negative about the market then he dial down the risk. Perfectly acceptable, but clients and advisers need to know the difference in order to judge how to monitor the portfolios.

Defaqto risk rate funds and MPS portfolios and it is fair to say that there are very few movements in risk grade over time whether risk targeted or risk focused, but there are some, so the adviser needs to be on top of this.

In summary, performance is not enough, it needs to be viewed in conjunction with a measure of risk that is suitable for the client. Investment manager and/or adviser need to have the client outcome in mind and if possible take as little risk with the client’s money as possible in order to achieve it. If the client goals are likely to be unachievable at a comfortable level of risk then they must decide whether to add risk or adjust their goals. 

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