Benchmarking your investments: Benefits and pitfalls

If you are unsure, it might be because you don’t have a benchmark for your investments or because you’re uncertain about the relevance of your current benchmark.

No wonder—it seems like benchmarking has turned into something of a religion, with asset managers holding various perspectives.

This article delves deep into evaluating your asset management through benchmarking, highlighting key aspects to focus on. This knowledge will equip you for more effective discussions with your asset manager.

Let’s start by laying down the basics.

What is a benchmark, and what is it used for?

At its core, a benchmark serves as a reference point representing a specific investment realm. This reference could take the form of an index like MSCI World All Countries, encapsulating global stocks, or S&P 500 index, encompassing 500 of the largest U.S. publicly traded companies.

The choice of benchmark depends on your investment strategy and risk profile. It’s crucial that the chosen benchmark aligns with your strategy for comparing portfolio performance effectively. We will delve into this further in the next section.

In cases where different asset managers tackle the same task, you could even consider using them as benchmarks for one another, comparing their respective performances. However, the term 'benchmark' more commonly refers to indices.

Investors often turn to benchmarking, especially in the case of active management, to continually assess whether a manager's performance outpaces a given index. This analysis is key to determining whether the active management approach justifies its higher costs compared to passive alternatives.

An index is a collection of securities representing a specific market slice. For instance, MSCI World All Countries tracks global stocks, while the S&P 500 mirrors the performance of the 500 largest U.S. publicly traded companies. Indices can also target specific sectors, such as Nasdaq representing the U.S. tech domain.

Indices are not limited to equities; they encompass other asset categories as well. Examples include indices reflecting the performance of German government bonds, gold, grain prices, and more.

Composite Benchmarks

In many cases, a composite benchmark composed of several indices with varying weightings is necessary. For instance, if your portfolio includes stocks, government bonds, and corporate bonds, you'd require an appropriate benchmark for each asset class. These individual benchmarks can then be combined into an overall portfolio benchmark, with weightings mirroring your investment strategy or the mandate you've provided to your asset manager.

4 Reasons Why Benchmarking Matters

Benchmarking is crucial because it serves as an essential tool for evaluating your asset management—whether you’re investing on your own or relying on professional asset managers.

1. You can use it to evaluate your returns

Earning a 10% return might seem like a significant achievement, as it reflects good profits from your investments. However, what if your benchmark records a 12% return? Suddenly, your gains don't appear as impressive.

This highlights the importance of not just assessing your return in isolation but considering your strategy's objective or the mandate you have provided to a manager. This contextualizes your return within the broader market landscape.

Interestingly, some managers exclude benchmarks from their return reports. In such cases, we encourage you to either request the inclusion of a benchmark or to compare your investments to a relevant benchmark yourself.

2. Benchmarking is Particularly Crucial When Using Only One Manager

If you have only one manager or if they operate under different mandates, you lack comparative managers for assessing performance. In such cases, we urge you to benchmark your manager's performance against another suitable benchmark.

3. You can evaluate if you’re getting what you’re paying for

When evaluating your capital management, adopting a holistic perspective matters more than hastily drawing conclusions from a single year. However, if you are paying for active management and your manager consistently falls short of the benchmark over an extended period, it’s wise to contemplate whether you‘re getting what you’re paying for. Explore the possibility of achieving equivalent or superior returns at lower costs through passive investing or with a different active manager.

4. Unveiling a Manager's Strengths and Weaknesses with Return Decomposition

If your strategy involves multiple asset classes, your benchmark should reflect the same asset class distribution and risk profile you aim for in the long run. Typically, your managers might have certain constraints dictating how much they can deviate from the long-term (strategic) allocation. The benchmark, however, should mirror the starting point of your investment strategy.

This approach empowers you to measure the extra return your manager generates by shifting investments between asset classes and thereby leveraging the boundaries you have agreed to.

If your manager opted to leverage this scope by, for instance, investing with slightly higher risk, you can evaluate whether this decision yielded a higher return than the benchmark or whether the increased risk did not translate into superior returns.

If your manager invested with the same allocation and risk as your investment strategy stipulates, you can assess where the manager's performance stands relative to the benchmark. This allows you to gauge their ability to select assets within the given constraints.

At Aleta, based on the latest research, we have developed an advanced return decomposition model. This provides insight into precisely how your managers generate returns—alongside how they do not.

In the following section, we delve into seven points to bear in mind when evaluating your investments and capital management through benchmarking.

7 considerations when it comes to benchmarking

1. Do you have the right benchmark?

It is crucial to use a suitable benchmark for your investments.

Your benchmark should reflect the risk and asset allocation in your investment strategy or the mandate given to an asset manager for portfolio management.

The mandate essentially describes the task you assign to your manager. If the goal is to manage global equities, it’s natural to choose a broad benchmark representing the performance of these equities.

However, if you decide to focus on a specific sector like US growth stocks, it changes the manager's task. In this case, finding a benchmark that represents US growth stocks might be more appropriate.

If you persist with a broad benchmark for global equities, you’d be comparing your manager's choices of US growth stocks against the entire global equity market. This approach might not effectively evaluate the manager's ability to generate excess returns within their given task, which is selecting US growth stocks.

Selecting the appropriate benchmark depends on who recommended the focus on US growth stocks, whether it is you or the manager, and thereby, who should be evaluated accordingly.

2. Does your manager consistently beat their benchmark?

If your manager consistently outperforms their benchmark, it is a good idea to ensure that the benchmark being used is appropriate. Taking ownership of the benchmark and being involved in determining which benchmark is used can be advantageous.

Some managers can adjust the benchmark used in their performance reporting, while others have more limitations. If the latter applies, you can independently compare the manager's performance against your chosen benchmark.

If you don’t have the time, we can assist you. We help all our clients select the most suitable benchmark for their investments, and it’s a standard part of our reporting. This is an area where we are highly meticulous, as we believe that an accurate benchmark is essential when evaluating your capital management.

3. Consider using a broad benchmark

As a general rule, you should utilize a relatively broad benchmark unless you have a specific view that calls for investment in a particular sector, geographic region, or similar consideration.

Even if you have set certain parameters for your manager, such as an asset class allocation and desired risk level, and the manager chooses to focus on a specific sector, it’s still recommended to evaluate their performance against a broad benchmark that represents the parameters you’ve given.

This approach enables you to assess whether the manager's decision to invest with a sector bias has resulted in a performance exceeding the benchmark or not.

4. Be mindful of costs

When evaluating your returns, it’s important to factor in the costs of management. For instance, let’s say your manager achieved a return of 8%, while the benchmark stood at 7%. This means your manager generated an excess return, often referred to as alpha, of 1 percentage point.

It sounds great, but if the costs of management exceed the achieved excess return, the return may not actually be above the benchmark when costs are deducted.

5. You should use an investable index as a benchmark

If a benchmark is composed of underlying securities that can be invested in, it’s referred to as an investable benchmark.

ETFs and mutual funds can track an index by investing in the assets that are part of the index. Using an investable product as a benchmark, such as a passively managed ETF or mutual fund that tracks a specific index, can be a good idea. Firstly, it’s most meaningful to compare your returns with an alternative that you actually could’ve invested in. Secondly, it provides a direct comparison to your manager's returns after costs, so you will not be met with the argument that constructing a portfolio following the benchmark index would be expensive.

6. Can you use your managers as benchmarks?

If you have multiple managers and want to use them as benchmarks for each other, there are several things to consider.

First and foremost, you need to make sure that you’re comparing managers who invest based on the same investment guidelines. Alternatively, you can compare their risk-adjusted returns, taking into account that they may be investing with different risk levels.

Furthermore, there is often a difference in how managers report their returns. This is primarily due to varying calculation methods, differences in whether they deduct costs from return calculations, and variations in whether they account for dividend taxes.

Therefore, it’s essential that you first ensure that the return figures you’re comparing are calculated on the same basis. You can either take care of this yourself or collaborate with an independent third party like Aleta.

Delivering consolidated reporting is one of our core competencies, allowing you to have a comprehensive overview of your managers' performance based on the same calculation basis.

7. Benchmarking alternative investments can be challenging

Creating benchmarks for alternative investments like real estate, wind energy, infrastructure, and private equity can be challenging. If you have alternative investments, you need to consider how you plan to evaluate them.

For example, if you have invested in private equity, you can choose an equity index as a benchmark. Alternatively, you can assess based on whether the Private Equity fund has reached their hurdle rate or not. You can also use an equity index and add a certain percentage to it that "compensates" for the lower liquidity. It all depends on your approach to investments.