PAM Guide to Wealth Management

Investment performance

There are a number of ways of measuring and analysing investment performance. The most obvious method is to compare performance against a benchmark. A benchmark helps to identify expectations, set targets for investment managers and monitors whether those objectives and expectations are being met on an ongoing basis. By measuring portfolio returns on a cumulative and period-to-period basis, say quarterly, you are able to ensure that the portfolio is being managed according to your requirements on a consistent basis.

One thing to be careful about is not to swap the benchmark to simply reflect changes that the private asset manager has introduced in his portfolio. Part of the skill of the manager is to make asset allocation decisions within the terms of the mandate. If the manager goes overweight Japan, for example, and you then adjust the benchmark to replicate this, it will not show in the performance measurement and you will have neutralised the effect of his decision.

It may be best to use a tailored benchmark, to reflect your individual risk profile and investment objectives. A tailored benchmark should reflect the mix of asset classes that you hold in your portfolio.

One approach would be to construct your own benchmark, using a range of quoted indices that are available in the financial press, or on specific websites. This approach, however, can be difficult as there are a multitude of different indices available and some care is required to match the appropriate index to your assets. Perhaps the simplest example is that of benchmarking your UK equity exposure, depending on the composition of your UK equities. Either the broader based FTSE-All Share index may be appropriate or you may prefer to use the more concentrated Blue Chip index of the FTSE-100.

Most broadly diversified portfolios will contain overseas equities, fixed interest (bonds), cash and, increasingly, alternative investments such as hedge funds, commercial property and commodities. Selecting an appropriate index for each asset class and calculating performance for a portfolio in composite can, therefore, be both time-consuming and requires some knowledge and experience.

Even using cash as an absolute risk-free benchmark is subjective, as arguably you should also factor in the incremental rise in inflation on a cumulative basis, to match your investment timeframe, as inflation erodes the purchasing power of cash on deposit.

It can be argued, therefore, that the simplest way for you to measure your portfolio performance in composite is to choose one of the ready made private investors indices. There are four main organisations that provide this data and, broadly, the principles are the same, in that each offers a range of model portfolios, dependant on your investment objectives. The portfolios are typically either income generating (mainly UK equities and bonds), balanced (some bond exposure but more emphasis on equities including overseas equities) or growth orientated portfolios (a predominantly equity bias with limited cash and bonds exposure).

Asset Risk Consultants offers four Private Client Indices (PCI), which are generally recognised by professional advisers as the most reliable performance indices. The Financial Times also publishes private investor indices in its weekend edition, while WM Company offers a fee-based subscription service that is used by some professional investors. Trustnet provides daily data on Adviser Fund Indices through its website.

Private asset managers choose benchmarks against which they will compare their own performance. But you should not automatically use their chosen benchmark. You should evaluate how relevant a benchmark is to the manager's investment approach and risk profile. If necessary, obtain independent advice on this. There are a number of professional investment advisers who can assist you. Some of the most recognised of these sit on the PAM Awards judging panel.

You also need to consider the currency in which returns have been calculated by both managers and benchmarks. Many major market indices are quoted in a range of currencies and some offer a local currency option, in which the component parts of the index are calculated in the base currency of the assets they represent. But this may not be relevant to you if your living costs are in another currency. You should analyse returns in your own currency, to see whether portfolios are meeting your objectives. Most indices are calculated on a total return, or a price return basis, sometimes both, to enable you to see the returns, both with and without income reinvested.

One way of measuring the performance of private asset managers, or individual funds within your portfolio, is to compare risk-adjusted returns against other managers and funds with similar mandates. It is advisable to compare performance after fees have been deducted, to provide a true comparison between different private asset managers. Funds, on the other hand, can be divided into sectors, such as UK all companies, UK small caps, global growth and North America. Just because funds are in the same sector, however, it does not mean you are comparing like for like. The UK all companies sector, for example, comprises a myriad of funds with different investment mandates and risk profiles. Even within a sector such as UK small caps, not all funds will have the same risk profile and investment objectives.

Nevertheless, sectors enable you to compare the performance of the funds you are invested in against their peers and help you decide whether you should analyse further the overall performance of your private asset manager. They can also allow you to compare the performance of your private asset manager against other managers, who also have to contend with the reality of fees and expenses.

One way of evaluating a fund is by analysing its performance over discrete time periods. For example, a fund may be ranked 10th out of 100 funds over five years. This may appear to be impressive as a stand-alone performance. But if you look at its performance every year, you may find it is ranked in the top five funds over two of the five years, but also in the bottom 10 in two of the other years. You need to decide if you are happy with this level of volatility, which will be partly determined by the time period over which you are likely to invest. For many investors, consistent absolute returns have become their preferred objective in reaction to increasingly volatile financial markets.

Central to monitoring private asset managers is to evaluate the investment decisions that have led to higher or lower performance, which is known as performance attribution analysis. Simplistically, superior investment performance by private asset managers is driven by picking the right stocks and asset classes at the right time and then selling them at the most opportune moment.  You need to be able to ascertain whether good performance is the result of your manager's skill, or luck.

Attribution analysis can cover all aspects of a manager's performance. A typical attribution analysis would break down sources of performance into asset allocation choices, sector choices within each market and stock selections. Attribution analysis focuses on how much risk has been taken by deviating away from the benchmark and then how much out-performance has been delivered.

If a portfolio out-performs an index over a short or long period, this does not necessarily demonstrate superior stock selection, however. It is important to consider the level of risk taken by the portfolio manager. If a great deal of risk is taken but the manager only marginally out-performs the index, then you have to question whether the returns compensate for the extra risk taken.

It is thus beneficial to evaluate the risk-adjusted performance of your portfolio. There are a number of measures that can be used, but explanations can become very technical. Simplistically, what the measures are trying to analyse is how much out-performance, compared to their peers or the index, is being delivered through asset allocation, stock selection skill, or taking extra risk. The question is whether the extra risk is more than compensated by higher returns. If the added returns are worth less than the extra risk taken it is clearly not attractive. Ideally, it is best to put money with a private asset manager who can deliver out-performance without taking any added risk.

Common quantitative terms you will hear being quoted by advisers and managers are alpha, beta and risk return analysis values such as the Sharpe ratio. You may also be told of how well the portfolio is correlated to the benchmar. This is a statistical measure that will tell you if the manager has good tracking error to the benchmark. A value of 0.7 to 1 is good, 0 to 0.7 shows limited correlation and 0 to -1 shows inverse correlation, which means the portfolio is working in opposition to the benchmark.

Of course, there are different ways of measuring how much risk is being taken by your private asset manager. You have to decide whether the risk-adjusted return should also be measured against an index or cash. This will depend on your own risk profile and investment objectives.

It is worth noting there have been some debates between investment managers and academics on this issue. One argument put forward by some academics is that stock-picking success is a 'random walk' or attributable to luck. This is based on the belief in efficient markets, which means all publicly known information is available instantaneously to everyone and immediately factored into share prices. This means a retail investor can do as well as a professional investor. In reality, of course, the impact of this theory is limited by the fact that markets are not truly efficient.

The theorists make two exceptions. One is for investors who have information that is not publicly known. Second, is the belief that investors who select potentially more volatile stocks can out-perform the market. This second point is relevant and important to this discussion. To gain enhanced returns over the long term, it may be necessary to take higher risks. The key is to achieve as high a return as possible from the least possible risk taken.

Another complication comes from the fact that risk is not constant, whether it is for a fund or a portfolio. Therefore, you need to monitor risk on an ongoing basis.

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