Your investment strategy has delivered a 10% return for the year, and you are satisfied. What if you then heard that that inflation for the year was also 10% - does this change how you feel? How about discovering that your colleague generated a 15% return or that the market generally delivered 20%? And how does all of this relate to your own investment goal?
By its very nature, determining success or failure in investments is often a relative endeavour, which makes defining your reference point a crucial first step.
A popular solution to this problem is to use one or more industry benchmarks to measure both market performance and individual portfolio performance. By aiming to reach or exceed specific benchmark returns, investors should get a better indication of whether they are on track to meet their unique investment goals. That said, it is critical to select benchmarks that are compatible with their investment strategy’s risk-return profile, or else the conclusions they draw may be misleading. A commonly-used benchmark to measure investment performance is an inflation-relative benchmark. For example: A return of inflation plus 2% over rolling 7-year periods.
These benchmarks became popular with the growth of “goals-based investing”; to increase assets by more than inflation so that wealth increases in real terms. A key advantage is that it is simple to understand and calculate and is also intuitively appealing because investors tend to recognise that inflation erodes the purchasing power of their savings.
However, we would argue that this measure should be viewed as a long-term investment objective rather than a benchmark. Although a benchmark should be aligned with a specific long-term objective, the benchmark itself is merely a comparison point, while the latter is a result that is both personal to the investor and expected from pursuing their investment strategy.
We carried out an analysis using a 2022 benchmark survey and found that there was a decline in the use of inflation benchmarking to assess investment performance, with figures suggesting a 15-percentage point decline in usage in the last two years. We postulate that using a return above inflation as a benchmark can be problematic because it generally requires measurement over long periods (seven years in the above example). And while inflation is (normally) a fairly stable number, investment returns are expected to vary greatly from one year to the next.
Over shorter periods, performance relative to the inflation target will differ significantly without informing investors if they should be concerned or if adjustments are required. Therefore, understanding the reasons for investment outcomes over different periods increases the level of investment education. And the deeper one’s understanding is, the more likely it is that better investment choices will be made.
Taking into account the shortcomings of inflation-linked benchmarks, another popular approach is that of peer-relative benchmarks. Example: The strategy’s objective is to outperform its peer group over meaningful periods (defined as at least 5 years).
Peer relative benchmarks can be thought of as a version of “keeping up with the Jones”. The idea is that investors should be happy with their investment performance as long as they come in the “top half of the class”.
However, in our view, there are several serious issues with this approach, the main one being that it doesn’t relate to a meaningful investment objective. Although it might feel better to know that someone else has had a worse outcome, investors should focus on achieving their investment objectives. Another problem is that it’s difficult (if not impossible) to define a reasonable peer group to compare to, so the comparison is unlikely to be fair.
When constructing an investment strategy, the starting point should be to define the investment objective. For example, this could be to fund a particular expense or achieve an absolute or relative return. The next step is determining the most appropriate asset allocation to achieve this outcome.
Indices make ideal benchmarks because they represent good returns earned from a particular asset class. This way, asset allocation can effectively align the benchmark and the investment objective.
Index-relative benchmarks also enable practical performance analysis to help investors understand whether the difference in performance relative to the benchmark was because of decisions relating to asset allocation or stock selection, as one example. Performance can also be monitored over short and long investment periods, allowing for better understanding and decision-making.
The bottom line is that once investors decide on a suitable benchmark or combination thereof that suits their unique risk profile, investment goals, time horizon and asset allocation, it should be used to evaluate their portfolio and provide a guideline for adjustments and re-balancing it on a regular ongoing basis to help manage risk effectively.
RisCura has long promoted goal-driven investing and uses a blended approach to benchmarking to satisfy unique client needs and requirements as a pioneer of investing with care.
Jonathan Brummer, Investment Consultant, RisCura
