Broaden the conversation

At almost every annual review meeting, the common "how are we doing?" question will undoubtedly come up.

Although a portfolio’s performance and investment return are both measures of success long-term, the art of benchmarking is the precise form to track relative performance and broaden discussion to the total portfolio.

Benchmarking, in its simplest form, is the standard to analyze and understand how a portfolio performs against the market or various segments of the market. The practice of benchmarking, however, is not as simple.

Before you incorporate benchmarking into your investment offerings, first understanding and explaining the various approaches will help your clients better understand their appetite for risk tolerance, investment goals, time horizon, and asset allocation.

Types of benchmark strategies

  • Market Index: Portfolios are rarely built to mimic a single index. By use of diversification to moderate risks, a strategy may underperform any single given index. This form of comparison is often best suited for specific holdings analysis.
  • Blended: A blended measurement of various asset indexes may not represent the changes a portfolio experiences over time. Rebalancing, contributions, and withdrawals may increase the challenge to accurately compare relative performance. While often most suitable for comparison of a diversified portfolio, an understanding of the complications is helpful.
  • Point-In-Time: As the market ebbs-and-flows, portfolio allocation may change. Over the past 10 years, a buy-and-hold, balanced (50% bond/50% stock) portfolio would have turned into roughly 70% stock and 30% bond1. Choosing a benchmark based on the allocation at the beginning or end of any period could lead to misleading results.
  • Goals-Based: While this can be a useful tool, it should not be relied upon in a vacuum. Expectations can be too lofty, or too muted based on a desired outcome. This can lead to unwelcome results and unsatisfactory outcomes.

Index methodologies

Indexes are all built differently, representing a hypothetical segment of the financial market. Some indexes have values based on market-cap weighting, revenue-weighting, float-weighting, and fundamental-weighting. Weighting is a method of adjusting the individual impact of items in an index.

The most widely used equity indexes are cap-weighted, meaning the largest companies hold the largest share. Whereas the most popular bond indexes are issue-weighted; the largest issuers hold the largest share. Indexes do not include cash exposure, but investable vehicles must maintain some level of liquidity in order to meet redemptions, as well as a result from selling and seeking opportunity. To make this more complex, a market must be liquid and available to easily replicate. Not all indexes are easy to replicate. Here are two examples of indexes that don’t represent how portfolios are often built:

  • The Bloomberg Barclays U.S. Aggregate Bond Index is the most widely used form of measurement for fixed income investing. This index is comprised of nearly 38% United States Treasury debt and an additional 27% U.S. government-backed agency debt2. It is unlikely that many bond portfolios are built in this mold.
  • The MSCI Emerging Markets Index captures 26 countries across the globe. Emerging markets have enhanced returns and created risk diversification opportunities for global equity investors, however because Chinese exposure accounts for over 40% of the index and roughly a third of that is state-run business3, many active managers choose to avoid these companies.

Of course, an investor cannot directly invest in an index.

The portfolio holdings matter

Portfolios are not built to track or mimic a benchmark. Instead, portfolios are built specific to your goals, objectives, and/or tolerance for risk. They are built for long-term achievement moving forward, not near-term speculation. This comprehensive focus may provide for lower volatility, income generation, capital preservation, or a number of reasons that are obsolete to any benchmark. Further, the index does not care about volatility and risk. But an investor should as they seek to give up some upside potential to protect on the downside. While markets have been exuberant for some time now, that protection should ultimately lead to better results.

The bottom line

In a perfect world we would measure not only performance, but also risk and allocation. In addition to an investor’s appetite and capacity for risk, goals and objectives are important items to track. Maintaining an Investment Policy Statement (IPS) and Comprehensive Financial Plan are often best resources to outline overall goals and objectives. The ongoing review of a plan can lead to solace, as well as dynamically modifying objectives as needs change over time.

About the authors

D. Wiley Moody, Director of Investment Planning

As a member of the Investment Strategy Group and Investment Steering Committee, Wiley is one of the forefront individuals involved with Lincoln’s Investment Strategy, Policy, and Implementation. This includes the development of Capital Market Assumptions, Asset Allocation Models across various platforms, and recommended mutual fund and exchange-traded fund lists that are widely used across the firm. Wiley currently services clients all over the United States in the high net worth marketplace and assists through committee involvement in overseeing and implementing over $30 billion in assets.

John W. Schatz, CRPC®, Director of Financial Planning

John Schatz joined Lincoln Financial Advisors in 2000. John is currently a Director of Financial Planning and Investment Planning. John not only works with planners within his offices, but also nationally with planners and managers throughout the Lincoln Financial Network. John has also been in private practice since 2002. He specializes in investment and estate planning for the affluent.

Securities and investment advisory services offered through Lincoln Financial Advisors Corp., a broker-dealer and registered investment advisor, member SIPC.