As I reviewed semi-annual performance reports for clients, I found myself thinking about this question. Our reports tell our clients the return on their portfolio for the year to date, the past three and five years. These are absolute returns, after all costs, which can be used to relate to individual needs and risks. If your financial plan shows a return of say 5% is required each year and your return is more, then things are looking positive, and a cushion is being built. If the return is less, then some changes may be required – save more, spend less, work longer.
Of course, we know that it is impossible to generate a consistent annual return when investing in a diversified portfolio containing a number of asset classes. When the markets declined in 2008, we recalculated our long term projections for clients, using the lower asset values, to determine what actions may be required. We have since compared actual to projected results at the end of each year, thus keeping the planning current and meaningful.
Absolute return should be the most relevant to a retail investor. However, our world is full of news and talk of relative returns. How did my portfolio perform compared to my neighbour’s? How did that fund manager perform relative to all funds in the class? How did that pension fund perform?
In order to look at relative returns, a “benchmark” must be established. And here is the first step in the imperfect world of relative returns. Many benchmarks can be supported as valid. For example, comparing the performance of a Canadian equity fund to the S&P/TSX Canadian Composite index is a commonly used benchmark. Or comparing to the peer group – i.e. all Canadian equity funds – is another. But there are many factors and strategies that can be built into the Canadian equity component of a portfolio (or any asset class, for that matter) – holdings in small companies versus large, value versus growth, concentration on a certain sector, to name a few. Should each of these be built into a benchmark?
Index suppliers such as Standard & Poor’s, Dow Jones, Russell, MSCI, FTSE, DEX and others build and maintain indices based on many criteria, often including the strategies referred to above. But if the “value added” benefit of a particular approach or manager relates to the use of a particular strategy (or dare I say stock picking ability!) should that be reflected in the benchmark? Or should the comparison be made to the broad market?
Similarly, should a benchmark be a weighted average of the components that are targeted to be in a portfolio – i.e. 40% fixed income, 20% Canadian Equity, 20% US Equity and 20% International equity – even if the manager chooses not to be in US equity for some period of time?
And don’t forget that it’s impossible to replicate an index without incurring costs. So those benchmarks come without any costs, making it difficult to compare “apples to apples”.
Performance reports from PWL report absolute returns for clients. (Securities administrators are contemplating making this a requirement for all securities and mutual fund dealers.) When we meet to review your portfolio and the performance report, we also review benchmark returns which compare your return to the broad market indices of each component of your portfolio.
One of our jobs as your professional investment management team is to keep your portfolio in balance. What does that mean? When we start working together, our Investment Policy Statement represents our job description. It outlines your personal asset allocation and requires us to stay within a defined band on each side of the allocation for each asset class.
These percentages can go awry because one asset class does better than another. Since stocks have a higher expected return than bonds, we usually anticipate the equity allocation will exceed its target. When this happens, a rebalancing is necessary – moving funds into the lower performing class to bring allocations back to the IPS levels. This results in selling high and buying low – always the objective, but not always the reality for many investors. There is no speculation on whether or not the asset class will continue to do well – market timing is not an efficient investment management strategy.
Interestingly enough, the 2008 equity markets caused allocations to be misaligned the other way – bonds outperformed stocks. Did we apply our rebalancing principles in those most unusual circumstances? The answer is yes. When the equity markets seemed to be free-falling, our conversations with clients were focused on holding the course we had set. We cautiously rebalanced while tempering the fear.
Other considerations come into play when looking at rebalancing. If a sale of assets is required, will there be capital gains tax issues? Alternatively, can cash flow into the portfolio be used for rebalancing rather than triggering a sale? Cash flow can be in the form of income from investments held, or new funds being deposited. This is one of the reasons we often have income distributions paid in cash rather than reinvested within our portfolios.
The IPS is a basic roadmap for your investment management. At PWL, our job is to ensure you stay on track and rebalancing is an important part of the risk management within your portfolio.