Building a good portfolio benchmark should be in the job description for all advisors, according to investment counsellor Richard Croft. Croft and Eric Kirzner, professor of finance at the University of Toronto’s Rotman School of Management, designed the only standard portfolio indices in Canada, the FPX series, whose valuations are published every day in the Financial Post.
Experts in building benchmarks believe that, with the right math and the proper expectations and delivery, any advisor can build a benchmark for his or her clients — setting up a context in which to deliver better results and education about asset allocation and risk, and through which to build a stronger relationship with the client.
“When I set our benchmarks, it’s as much about helping the client understand what we do,” says Croft, president of R.N. Croft Financial Group Inc. in Toronto and a columnist for Investment Executive. “As clients get more and more understanding of that, it turns out to be a good sales tool.”
A strong benchmark relevant to clients should have three general qualities, Croft says.
> Unambiguous. The first quality is that it should be unambiguous. Its composition should be published and should clearly state how its value is determined and reported.
Advisors can assemble portfolio benchmarks from a handful of well-known indices. Institutional and private-client asset managers choose the most widely recognized indices to begin building their portfolio benchmarks.
“It depends somewhat on the client’s sophistication,” says Chris Ambridge, vice president and head of investment management at First Asset Advisory Services Inc. in Toronto. “You want something familiar to clients, but it needs to reflect their goals accurately.”
In Canada, the most obvious choice for equities is the S&P/TSX composite index, Kirzner says. If the client is holding just a handful of large-cap stocks, you could move down the scale to the S&P/TSX 60.
For fixed-income, the most unambiguous choice is the deck of Scotia Capital Inc. indices. Typically, you would use the long index.
For international equities, the Morgan Stanley Capital International Inc. Europe, Australia and Far East (MSCI EAFE) index is the clearest to explain to clients: it contains large-cap international stocks that they will recognize, such as Finland’s Nokia Oyj or HSBC Holdings PLC of Britain.
In the U.S., the most common is still the Standard & Poor’s 500.
> Measurable. The committees that build major indices apply different rules for the makeup and valuations of these key indices. Securities need to break certain trading volumes and weighting thresholds to gain entry. What’s important is the mathematical consistency.
Advisors also need to do the math and explain it to their clients. As Croft says, portfolios can be split between equities and fixed-income “six ways to Sunday.” In our example, we’ll assume a breakdown of 60% equities to 40% fixed-income for the moderate growth investor.
After you build the client’s portfolio, assign a portion from each asset category to a corresponding major index to serve as a benchmark to that portion.
For example, your client’s 40% weighting in fixed-income might be benchmarked by the Scotia Capital universe bond total-return index. If your client’s 60% equity holding is split evenly among Canada, the U.S. and international weightings, then you’ll assign 20% to each of S&P/TSX composite, the S&P 500 and the MSCI EAFE indices.
When it comes time to review the portfolio, you will multiply the rate of return on the bond index by 40%, plus each of the rates of return for equity indices by 20%. Add them together to compare your client’s total return. You can also review the total return on each portion of the benchmark to see what part of the portfolio is adding value.
“We do it quarterly for our clients because that’s how we review performance,” says Ambridge.
Current daily and monthly data for each of your benchmark constituents can be gathered from Web sites or newspapers. Building historical models of your benchmark, however, could be expensive, as the data providers charge a fee for the information. Services such as Bloomberg LP or Reuters will cost upward of $20,000 per year.
> Appropriate. The third quality for a strong benchmark is that it is the most appropriate. An advisor needs to be vigilant about which bond index, for example, is used as a benchmark. Subindices for short- and medium-term bonds are available, if that’s where your client lies on the curve, Kirzner says.
@page_break@Similarly, advisors should consult Merrill Lynch & Co. Inc. for U.S. and international small-cap indices, and BMO Nesbitt Burns Inc. for Canadian small-caps if your client owns any portion of those asset classes. With the foreign-content cap lifted for registered accounts, some client portfolios may be tipped more heavily toward international stocks than those in the U.S. and Canada. In such a case, the MSCI world index is an option, because it represents a weighted average of stocks from each country.
Benchmarks of all stripes and sorts exist, Ambridge says, including real estate and hedge fund indices for clients who have invested in alternative assets.
If the index is inappropriate, the client won’t know if the advisor is adding value, nor will the advisor know if the stocks or funds in the portfolio are ticking properly.
This is when client education about asset allocation and risk management comes into play.
“Sometimes they aren’t even comparing apples to oranges,” says Ambridge. “They’re invested 80% in income trusts and energy in another portfolio because that’s been hot lately, and they say they’ve outperformed our benchmarks, but in reality we’ve done extremely well relative to what we’re trying to accomplish.”
Meanwhile the client doesn’t understand how much risk has been taken on until he or she gets burned, Ambridge adds.
Here, the complete context of the benchmark is most important, Kirzner says. The client and the advisor are supposed to set a reasonable goal for an absolute return based on an asset allocation that corresponds with the client’s goals and risk tolerance. For example, it may make sense to set a three-year absolute rate of return of 8% annually for the client. The client is not going to expect that every year, but should accept the average.
“So, I can be reporting how we are doing relative to the absolute benchmark and then how are we doing against the portfolio benchmark itself,” Kirzner says.
> Investible. A fourth aspect that might be considered is that the benchmark should be investible. Index funds or iUnits are available for most indices and benchmarks, so your clients could buy those as an alternative to the stocks and funds you’ve bought for them.
This brings up the thorny issue of cost and value, because an advisor needs to receive compensation for the cost of his or her advice. In that sense, a direct comparison of index performance to a portfolio is not fair because there are fees associated with buying a portfolio. “You can buy those indices cheap,” Kirzner says, so it’s only fair to shave 40 basis points off the benchmark returns.
An advisor should also be prepared to argue in a tight spot that he or she is not investing solely against a benchmark, Croft says. An advisor is investing against the client’s capacity to do it him- or herself.
Finally, the advisor can also focus on the risk of the portfolio vs the risk of the benchmark, he adds. If the advisor calculates the standard deviation for both the index and the client’s portfolio and then adjusts the rates of return for risk, it makes for a better discussion with the client. “And I think it frames the advisor as better professional,” Croft says. IE