Originally Published: September 27, 2011, Phocion Investments; August 6, 2015, NYSSA’s The Finance Professionals’ Post
Investors are presented with a barrage of marketing material from funds and managers trying to raise capital, and what all these reports have in common is that they all focus on performance. That is not surprising considering the relatively large number of funds available with the few strategies being used, managers feel they can only differentiate themselves through performance. Attend enough sales presentations and you will have heard how “my long-short equity strategy has consistently outperformed the market and that is why you need to invest with us.” By the way, the “Past performance is no indication of future results” is usually said with much less gusto.
This is not to disparage managers and funds alike but rather to help investors identify the good managers whose past performance is more than likely a good indication of their future performance. Although a thorough performance evaluation requires the skill set of a performance specialist, any investor can begin such an evaluation by questioning one simple and important component of the performance marketing material, which is the benchmark.
What Are We Missing
As a performance specialist, my first reaction to any performance report is to question it. This is not to say we should all have a mistrust of performance presentations but rather a curiosity as to how that performance was achieved. Unfortunately, much of this curiosity is suspended far too often for investors. Perhaps this is a reason why many of them just accept the benchmark as a fair comparison for the portfolio. There are different types of benchmarks, from market indices to custom security based and knowing enough about them will help investors gain greater insight into the skill of the manager.
What about absolute return strategies? The decision not to have any “physical” benchmark does not mean that there was no benchmark choice. Establishing a target return still constitutes a benchmark choice. Taking it further, investors fail to ask some simple questions: Do the risk characteristics of the benchmark resemble that of the portfolio? Does the benchmark and fund cover the same portion of the market? Overall, is it really a fair comparison? Failure to ask these questions is analogous to a racing team deciding on a driver by comparing one in a Formula One car and the other in a Honda Accord. It sounds ridiculous but this is what happens in fund/manager choices.
What Are Quality Benchmarks
How can we improve the evaluation process? We can first begin with some basic understanding of what makes a good benchmark. A benchmark is usually some passive alternative that is used to evaluate the performance of a manager following a similar approach but with an active element. The CFA Institute lists the following seven important characteristics in defining a good benchmark[i]. They are:
Unambiguous: The identities and weights of securities or factor exposures constituting the benchmark are clearly defined.
Investable: It is possible to forgo active management and simply hold the benchmark.
Measurable: The benchmark’s return is readily calculable on a reasonably frequent basis.
Appropriate: The benchmark is consistent with the manager’s investment style or area of expertise.
Reflective of current investment opinions: The manager has current investment knowledge of the securities or factor exposures within the benchmark.
Specified in advance: The benchmark is specified prior to the start of an evaluation period and known to all interested parties.
Owned: The investment manager should be aware of and accept accountability for the constituents and performance of the benchmark. It is encouraged that the benchmark be embedded in and integral to the investment process and procedures of the investment manager.
Once each characteristic has been evaluated, the work continues by answering some of the questions I posed before. Look into the risk characteristics of the benchmark and compare them to the portfolio. Verify whether the portfolio covers the same investment horizon as the benchmark. Even if an absolute benchmark is used, apply a comparable physical benchmark yourself so you don’t rely solely on the manager’s evaluation.
Moreover, it is not out of the ordinary for manager’s to change benchmarks over time, and sometimes for valid reasons, but it is the investors’ obligation to verify the benchmark history of the funds. Managers’ who rely on a “floating” benchmark to outperform are not managers who can ever offer you any alpha. They more than likely lack any investment thesis to explain and support their strategies. Good managers are able to clarify their out- and underperformance with a detailed evaluation of their thesis. Poor managers blame market conditions for underperformance and rely on the ignorance or trusting behavior of investors for acceptance of their explanation.
Investors seek managers who are better than their peers who can make them money. For that reason, both absolute and relative performance should be looked at. This approach will answer two very important, and complementary, questions: “Did the manager make money for me? Was he better than the alternative (i.e. benchmark)?” Taking this approach will help investors considerably more than just relying on absolute or relative performance alone.
Marketing performance reports require the thorough evaluation from every investor before their hard earned money is invested with any manager. Standards have been created to help investors receive a fair presentation of performance but these standards are not mandatory. Would making them mandatory ensure funds are marketed fairly? Perhaps, but humans’ creative nature would always find a way to circumvent that. On the other hand, if all investors were better equipped to ask the right questions and properly evaluate performance, then funds would be held to a higher standard and to the well informed demands of potential clients. Raising the level of demand is most often than not the most efficient and fastest way of improving the overall industry. McDonald’s would still be selling only burgers and fries if not for the growing demand from consumers for healthier options.
[i] Jeffery Bailey (1992a); “Evaluating Portfolio Performance”, CFA Institute.