Graham Westmacott CFA

Portfolio Manager

Susan Daley CFA

Associate Portfolio Manager
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Weighed, measured and found wanting

September 26, 2014 - 0 comments

Benchmarking performance may conceal more than it reveals. We look at the latest initiative from Canadian regulators of investment firms.

Investment firms will soon be obliged by regulators to benchmark their performance or explain why they choose not to do so. The hope is that such information will better enable investors to assess their portfolio’s performance1.

At PWL we see ourselves as investor advocates and so the case for benchmarking performance seems, at first glance, unassailable. To be unwilling to benchmark performance raises the question of “What have you got to hide?”

There are genuine problems with selecting good benchmarks but this shouldn’t disguise the main reason that many advisors will not want to do this is because they will appear to underperform against any reasonable benchmark. Take for example an investor with a broad allocation to Canadian equities. A reasonable benchmark would be the S&P/TSX Composite Index. This represents the overall market and is the average performance of all the market participants before investment fees. But investment fees have to be paid so the average investor will underperform the benchmark. This is well known, but easily forgotten. Even if fees are ignored then how many advisors fear that achieving the benchmark will be seen as only average and don’t clients expect more? Certainly if advisors have been telling their clients that they are able to beat the market, then this is going to lead to some awkward conversations. Real portfolios, compared to ideal benchmarks, also have to deal with incoming and outgoing cash, withholding taxes, exchange rate spreads and other frictional costs all of which contribute to performance lag.

Fiddling the books

The pressure to be seen to over-perform can also lead to the selection of an inappropriate benchmark that is easily beaten. An actual example would be the equity fund manager who benchmarks performance against a risk free rate (e.g. the bank rate) and rewards themselves a 20% performance fee when they outperform the benchmark! Alternatively, a Canadian equity fund manager might decide to bias their portfolio toward small company stocks that have a higher return, but also a higher market volatility in an attempt to beat the S&P/TSX. A discussion of how Canadian fund managers juiced their returns in 2013 by including U.S. stocks to outperform their benchmark may be found here.

The lesson for investors is that advisors and fund managers who claim to be able to “beat the market” or generate alpha, find the easiest (and perhaps the only) way of doing this on a consistent basis is to use an inappropriate benchmark.

What constitutes a good benchmark? A good benchmark should be:

Well Defined

So, for example, the S&P/TSX is a well defined public index of Canadian companies ranked by market capitalisation. The benchmark “the top 20% of Canadian equity fund companies” would not be suitable because it is not knowable in advance.


There are many low cost investments that track the S&P/TSX, for example, so this would be an investable benchmark. Selecting an absolute return of, for example, “in excess of 5% annually” is not an investable alternative and hence not an appropriate benchmark.

Adjusted for risk

Our example of an equity fund using the risk free rate as its benchmark is inappropriate because investing in equities is far riskier. Investors should expect additional compensation over the risk free rate for that risk. Similarly using the broad S&P/TSX as a benchmark for a small cap fund is comparing a high risk investment with a low risk investment.

Even if the benchmark satisfies these criteria, the time period of the comparison is also important. Comparisons over short (less than a year) time periods are not very meaningful and very susceptible to changing start and end dates. Conversely, benchmarking portfolio over several years many span periods when there have been different investment objectives for the investor.

In spite of these challenges and the potential for misleading rather than helping investors, the lesson from less regulated parts of the market such as private equity and hedge funds is ”if you think education is expensive, try ignorance”. According to the consulting firm PERAC, 75% of private equity firms claim to be in the top 25%2 - a feat achieved because of a lack of consistent benchmarking. Hedge funds pursue such a wide range of often opaque, highly non-linear strategies that are leveraged and illiquid, making it very hard for investors to assess whether they add any value. In a recent review Ang (Ibid) concludes” HFs [hedge funds] ..are probably subtracting value from investors on a risk-adjusted basis”.

Missing the target

Arguably, even if benchmarking can be gamed to mislead, for the savvy investor this may be a clue that they do not have the right relationship. The personal view of the author is that the focus on benchmarking is misplaced. It is as if an accountant were to be asked to show how each line in their accounts complied with Canadian Accounting Standards: we assume that accountants, as professionals, adhere to a professional standard. The financial industry’s regulators shy away from imposing a fiduciary standard – one that acts in the client’s best interest. Disclosing benchmarks that raises more questions than answers thrusts the onus on the investor to supervise advisors and investment managers rather than have them step up their game. In the absence of a fiduciary standard, the investor may be about to receive more data but not a lot of useful information.

As always we welcome your opinions.

1 The method for calculating returns that the regulator is requiring is not the same that is used when calculating benchmarks. This adds an additional layer of confusion that is well elaborated here.
2 As referenced in Asset Management, A Systematic Approach to Factor Investing, Andrew Ang (2014). One of the common methods for calculating returns of private equity funds, IRR or money weighted returns is particularly misleading in the private equity context, but is the same method being recommended by Canadian regulators.

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