Performance measurement and reporting was once considered one of the dark arts of portfolio management. Calculations were mysterious and everybody did them their own way. Unless clients dug deeply into the nitty-gritty of investment manager performance calculations, they had no way of knowing how one manager’s performance truly compared with another’s.
That began to change in 1987 when the Association for Investment Management and Research (AIMR) released their Performance Presentation Standards, a set of voluntary standards for investment managers in the United States and Canada. The AIMR refined those standards over the years and today they are known as the Global Investment Performance Standards, or GIPS. The AIMR, now known as The CFA Institute, is the still the official arbiter of GIPS and every few years they publish updated standards to stay current with the rapidly changing world of investments.
I started with this brief history lesson to illustrate two important points. First, professional investors understand that measuring investment performance is a vital part of investment management. Second, accurately measuring and reporting investment performance is not as easy as it might appear. Some very smart people wrestle with these issues on a full-time basis. Their best thinking eventually gets reflected in the standards that drive the numbers we see in various publications.
To be successful as an investor, you need to continually ask yourself a series of questions that will help you evaluate your portfolio: Am I making progress toward my goals? Is my portfolio structure correct for my objectives? Are the risks in my portfolio consistent with my unique situation? Are my investments paying me for the risks I am taking? Are there superior investments I should consider?
A good place to start the evaluation of your portfolio’s performance is to define an appropriate portfolio benchmark. There are two types of benchmarks that can be very helpful: market benchmarks and objective-based benchmarks. A market benchmark is typically based on an index like the S&P 500. However, a single index is rarely adequate for measuring the performance of an overall portfolio. Measuring a portfolio of stocks and bonds against an all-stock benchmark index results in classic apples-to-oranges problems.
A better approach is to create a composite benchmark based on a set of appropriate market indices that are weighted to match your portfolio’s long-term asset allocation. For example, if your target asset allocation is 60 percent US stocks and 40 percent investment grade bonds, you could build a composite benchmark that is 60 percent S&P 500 index and 40 percent Aggregate Bond index. Keeping track of a composite benchmark is more complicated, but it can be done in an Excel spreadsheet. However, your investment advisor should have GIPS-compliant software to do it for you.
An objective-based benchmark is more complex. It looks at your portfolio’s performance relative to the goals you have set for yourself. A simple objective-based benchmark could be a target rate of return. For example, let’s suppose your financial plan stipulates that you need to earn an average annual return of 8 percent on your investments for the next ten years in order to meet your retirement goal. You can use that target return as an objective-based benchmark. There will be some years when you outperform the 8 percent target and other years when you underperform it, but the key test is whether you meet it over the course of your ten-year horizon. Again, you can track your performance relative to the benchmark in an Excel spreadsheet, but you are probably better off having your investment advisor track it.
If you use a market benchmark or a composite benchmark, you can analyze your portfolio using a technique called performance attribution. Full performance attribution is complex and requires sophisticated analytical skills. However, simple performance attribution can help you answer questions such as, “how much did my portfolio’s overweight or underweight in stocks relative to my benchmark contribute to my portfolio’s over- or underperformance?” or “how much did the outperformance of my equity holdings contribute to the overall performance of my portfolio?” Understanding the answers to these types of questions can help you see if you need to make changes in your investment approach. Once again, these are questions that you advisor should be able to help answer for you.
Steven C. Merrell MBA, CFP®, AIF® is a Partner at Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey. He welcomes questions that you may have concerning investments, taxes, retirement, or estate planning. Send your questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA 93940 or email them to:Smerrell@montereypw.com