Benchmark Review

In the latest paper published by Charity Business Mark Freeman looks at how trustees can set effective benchmarks for risk and return with their investment portfolios.

1. SUMMARY
This report sets out the methodology of how an organisation should go about setting its benchmarks and asset allocation based on the required returns it needs to operate with an the associate risk that it brings with it.

2. RECOMMENDATION
Before any organisation makes any changes to its benchmarks and asset allocation it should review is required level of return and its risk appetite to ensure that these match with those of the Trustees as a whole.

The organisation should consider including in the annual performance reporting a report on the level of risk in the portfolio relative to the market place so that it understands the degree of additional risk it has taken on to achieve the levels of return it requires.

3. BACKGROUND
Performance measurement should not be reduced to the evaluation of fund returns alone, but must also integrate other fund elements that would be of interest to investors, such as the measure of risk taken. At the present time for most organisations the measure of risk is ignored or implied by the type of benchmark that they have chosen. Several other aspects are also part of performance measurement: evaluating if managers have succeeded in reaching their objective, i.e. if their return was sufficiently high to reward the risks taken; how they compare to their peers; and finally whether the portfolio management results were due to luck or the manager’s skill.

Portfolio benchmarks variance is obtained by measuring the difference between the return of the portfolio and that of a benchmark portfolio. This measure appears to be the only reliable performance measure to evaluate active management in the short term.

4. RISK AND ASSET ALLOCATION
When structuring the arrangements with an Investment Manager the starting point is what is the required real return needed by the organisation as well as taking account of any restrictions related to the funds.. Real return being defined as the performance above inflation to ensure that the funds do not diminish in value over time. In setting this requirement the an organisation needs to consider its risk appetite and ultimately the risk it is willing to take on. By this we mean if the an organisation requires a greater than normal amount of real return then the level of risk will increase which will lead to higher volatility in the performance of the portfolio.

Volatility refers to the degree of (typically short-term) unpredictable change over time of a certain variable, therefore, the greater the risk the higher the volatility. Higher volatility results in greater swings in the performance of the returns over shorter periods of time. The level of volatility is determined by looking at the historical volatility of the market as a whole over varying lengths of time. Historically total returns have been around 6.5% with inflation operating at 3.0% to 3.5%, therefore, the real return would be in the range of 3% to 3.5%. As a result of the an organisation setting a real return of 6% to 7% per annum it means that the organisation is willing to accept a level of risk that is 20 times greater than normally accepted in the market. As a result the organisation should expect to have greater swings in performance over the short terms both in terms of positive and negative performance relative to the market place.

The risk level is important as it then drives the asset allocation for an organisation to achieve the required return level. The basis of selecting the asset allocation and ranges is based on those asset classes that will provide the required combined return; those with low levels of annual return are unlikely to form part of the portfolio (e.g. cash or similar asset classes) and those that carry a greater risk will start to form the majority of the portfolio (e.g. equities).

The asset allocation range is provided to manage the risk associated to an organisation and in relation to the overall risk that an organisation is prepared to embody within the portfolio. This is the highs and lows that the investment manager is allowed to operate within. Without this the investment manager could take very long or short positions in relation to an asset class and increase the risk associated to the Trust portfolio. By setting these ranges the Trust is restricting the ability of the investment manager to take too much risk or not enough on its behalf. You would expect in normal market conditions that if the investment manger was not able to achieve the level of returns required by the Trust based on the restrictions that they would advise the Trust of this as well as the required ranges that it would need to achieve the return required.

As mentioned in the background there normally is no measure of risk within the reporting. It would be worthwhile having a measure of risk relative to the market within the quarterly or annual reporting so that the Trustees can evaluate the level of risk in the portfolio and compare it to their appetite for risk to ensure that it does not exceed expectations before making any changes to the benchmark unless the overall risk is unacceptable.

Earlier we mentioned that an organisation should expect returns to under and out perform relative to the market place and to manage and understand this performance this is where the benchmarks are used to gauge the quarter to quarter performance of the investment manager. The benchmarks do not represent the risk in the portfolio but are representative of the performance of that class of asset. The overall performance should mirror the short term performance required to achieve the longer term return that the Trust requires. By this we mean that in any one year an organisation is unlikely to achieve its stated requirement of 6% to 7% real return but over a period of 3 to 5 years, and with current market conditions potentially longer, this should be the return that the organisation is looking to achieve. This is the ultimate measure of the Investment Manager over time.

As it is not possible to assess the overall performance in the short term the use of indices benchmarks and their blended performance are used to gauge the performance of the manager over the short term (e.g. quarterly and annually). When the short performance is being evaluated the level of risk needs to be taken account of again to assess the performance relative to what has been asked of the Investment Manager to deliver over the long term. The higher the level of risk the more times that the performance will be likely to be out of alignment with the indices benchmark then if the risk was lower. The lowest possible risk relative to an indices benchmark is a tracker fund which will return the long term expected historical return of 6.5% or real return of 3.0% to 3.5% as well as return the indices return each quarter.

5. SUMMARATION
As set out above the benchmarks and asset allocation for an organisation are based on the level of return required by the organisation over time. To consider any changes to the asset allocation or benchmarks an organisation needs to start with an assessment of the level of real return it requires over time, which will then dedicate the level of risk required. This level of risk then needs to be assessed with what the Trustees feels appropriate. If the level of risk is too high then the real returns would have to be reduced which the organisation would have to consider.

Once the level of real return and the risk have been agreed and accepted then the asset allocation can take place. This may result in a further refinement of the risk appetite and required returns. Finally once all these factors have been refined and agreed the benchmarks that are appropriate to measure short term performance can be determined in connection with the Investment Manager.

6. CONCLUSION
The starting point for an organisation to review its benchmarks it must first review the level of real return required and the resulting risk from this. Provided the organisation accepts the level of risk then the asset allocation can proceed along with assessing the most appropriate benchmarks to assess short term performance.

Mark E Freeman CA(Canada)