Benchmarking and Sophistry

Sophistry, I love this word, it means to say something which is not itself untrue but which leaves an impression that is incorrect (it’s the staple diet of political rhetoric).

Benchmarking can be a practice in sophistry; an investor being told that a fund or portfolio consistently beats its benchmark, so giving the impression that the manager is doing a wonderful job but this is only actually meaningful if the benchmark is a fair comparator. Obviously the temptation is to lower the benchmark by including lower metrics to make outperformance against it much more likely.

When LWM was conceived the core criteria for its relevance and success was that we could, using our research, identify a coherent group of assets across all classes that would outperformed the market average. In addition and as explained in the last post, we could then adapt successful portfolio management techniques by rebalancing into assets which had underperformed to take advantage of the emotional failings of markets (people buying at the top and selling at the bottom).

A key question we discussed at great length was how exactly to measure portfolio performance, how to construct a fair benchmark?

THE PROBLEMS

These are in no particular order of importance and it’s certainly not an exhaustive list.

1. The US markets (including the Nasdaq) are valued at around $16 trillion, the next biggest market is Japan at ¥3.5 Trillion, the UK is at £2.8 trillion
2. A UK investors portfolio will have a higher proportion of UK holdings than is warranted by the size of the UK market which makes benchmarking to a single global index misleading as it won’t have the same proportionate split (if the UK is a good performer the benchmark will be hammered and vice – versa although the actual funds in the portfolio may be excellent or poor performers)
3. Foreign holdings are in fact two investments in one; firstly the fund holdings (US, Japan, Europe) and secondly the currency. This was illustrated by the Nikkei in 2013 rising 50% in local currency terms but only 25% in £ terms because of the depreciation of 25% of the ¥ against the £
4. If the benchmark is measured in local currency terms the benchmark performance will not represent reality for a UK investor
5. If the portfolio includes global property holdings, multi-national bond funds or global equity funds such as Scottish Mortgage, how can these be benchmarked as their constitution is an ever changing proportion of holdings in various countries

These are honestly only a fraction of the many conundrums.

THE SOLUTION

So we went back to first principles and asked ourselves what we were being paid to achieve.

Our answer was and is.

“To create a portfolio which outperforms the indices of the markets as measured by tracker funds”

So to explain.

We charge clients for researching and identifying best in class investments, the additional cost is not worthwhile if they can replicate or better the performance themselves and the most effective way for them to do this would be to invest in index tracker funds in the same % proportions as the portfolios.

George therefore constructed a portfolio of trackers (also known as “passives” as they replicate an index and don’t have “active” management). They invest in the same markets to the same proportions as the various LWM portfolios. The annual performance of these benchmark passive portfolios are then used as the comparative measure to those we actively manage.

It is certainly true that some index funds are not precise comparisons to the active funds they replicate but this is simply because a direct comparable does not exist. Passives are not designed to be sophisticated (to keep costs low) but we make sure we find the best and most accurate comparisons available.

George, who’s far more knowledgeable and learned on matters of portfolio construction, will be writing a companion piece to this note which will give details of the specifics.

CONCLUSION

We hope this explanation helps to reassure that whilst we may be many things, but we are not sophistrists!

COMPARATIVE PERFORMANCE

As Paul has indicated the dilemma for us is to create a benchmark which allows a client to fairly gauge the performance of the portfolios. Being shut away in the vaults of LWM gives me the opportunity to create and think this though and I believe as a result of this we have come up with something that is fair and accurate.

From our side there a number of reasons why a benchmark is important. This includes:

1. One of the most important aims is that we consistently outperform the benchmark over the long term. I would caveat this because there will be periods when active management is out of favour, 2011 was an example of this. We are seeing in the Portfolios from 1 July 2013 that European Active Funds are being outperformed by Passive Funds. However, the point for us, is that we are not trying to guess when one will be better than the other but act in the knowledge that over the long term the best active managers will significantly outperform
2. If a fund underperforms for 12 months (or even over a shorter period) it will become obvious when we review performance. What we are looking for are trends. If a fund is consistently underperforming, what is the reason? For example we removed the M&G Recovery Fund because for three years it had underperformed the benchmark and we believed that it would be very hard for the manager to turn the performance around. On the portfolios we currently have two funds which are in this position and are likely to be replaced in July
3. One of the arguments for funds which track the market is cost. If you can access a market for 0.25% compared to 0.75% for an actively managed fund then surely over time this cost saving will translate to better performance. We concur with this and hence Paul’s comment that if we can’t outperform over the long-term then there is no reason to have actively managed funds. I would add at this point that if we are in a sector where no funds actively outperform the benchmark then we would introduce funds which track the market

In summary what the benchmark does for us is constantly challenge our thinking to ensure we are achieving the best outcomes for clients.

Although these are important factors for us we know the key for a client is that they can judge our performance and if we add value.

How the benchmark is constructed

When constructing the portfolios the first step for us is to allocate the assets to sectors. For example, in the Defensive Portfolio we may allocate 59% of the Portfolio to Fixed Interest / Alternative Investments and in the Adventurous Portfolio we allocate 5%.

This is referred to as asset allocation and we use the same asset allocation for the active funds as we do for the passive funds.

Although we may use 25 funds in a portfolio we won’t do the same for the passive funds. What we have done is seek out 15 passive funds which mirror the holdings of the different funds we use. For example, although we have US Funds which focus on large, small and medium sized companies we track all of them against the iShares MSCI North America ETF. The reason for this is that one ETF tracks the cumulative performance of 3 funds.

In summary what we are looking to do is produce the fairest mix of exchange traded funds which we can then compare against the active funds.

There are two tables which illustrate this further. The first table shows how we have split the passive funds to create the benchmark and the second illustrates the performance of the underlying funds in the portfolios against their benchmark.

Asset Allocation

	Defensive Portfolio	Cautious Income Portfolio	Cautious Growth Portfolio	Balanced Portfolio	Moderately Adventurous Portfolio	Adventurous Portfolio
iShares Global Inflation Linked Govt Bond	47%	33%	33%	18%	6%	0%
iShares J.P.Morgan $ Emerging Mkts Bond	12%	10%	10%	8%	10%	5%
iShares Developed Markets Property Yld	15%	15%	15%	15%	5%	5%
iShares UK Dividend	4%	10%	6%	4%	0%	0%
Lyxor ETF FTSE All Share	2%	0%	4%	11%	15%	17%
iShares MSCI Europe Ex UK	5%	0%	7%	9%	9%	12%
iShares MSCI North America	5%	0%	7%	9%	13%	15%
DB X-Trackers MSCI Japan ETF	3%	0%	3%	4%	6%	6%
iShares MSCI AC Far East Ex Japan	2%	4%	4%	5%	6%	6%
iShares MSCI Emerging Markets (Inc)	3%	3%	5%	6%	9%	12%
ETFS All Commodities	0%	0%	0%	0%	3%	3%
ETFS Agriculture	0%	0%	0%	2%	3%	3%
iShares Global Infrastructure	0%	10%	0%	0%	0%	0%
Lyxor ETF MSCI World Health Care	0%	0%	0%	0%	3%	3%
DB X-Trackers FTSE All World Ex UK	2%	15%	6%	9%	12%	12%

Performance

 

Fixed Interest	Fund Performance	Benchmark Performance
M&G Optimal Income Fund	5.98%	-3.96%
Standard Life GARS Fund	3.66%	-3.96%
Threadneedle Emg Mkt Bond	-7.65%	-9.07%
Baillie Gifford Emg Markets Bond	-14.62%	-9.07%
Property
First State Global Property Securities	-8.06%	-10.09%
TR Property Investment Trust	24.22%	-10.09%
Schroder Global Property Income Maximiser Fund	-4.86%	-10.09%
UK Equity
Standard Life UK Equity Unconstrained Fund	20.04%	7.82%
Liontrust Special Situations Fund	7.00%	7.82%
Standard Life UK Smaller Companies Trust	17.17%	7.82%
Schroder Income Maximiser	10.66%	8.01%
Standard Life UK Equity Income Unconstrained	19.41%	8.01%
L&G UK Alpha Fund	29.50%	7.82%
US Equities
GAM North American Fund	4.03%	2.46%
Schroder US Mid Cap Fund	5.38%	2.46%
Threadneedle American Smaller Companies Fund	6.56%	2.46%
Baillie Gifford American Fund	1.16%	2.46%
AXA Framlington Growth Fund	12.31%	2.46%
F&C US Smaller Companies	5.24%	2.46%
European Equities
Threadneedle European Select Fund	0.73%	8.75%
Threadneedle European Smaller Companies Fund	4.82%	8.75%
Liontrust European Growth	6.61%	8.75%
Baillie Gifford European Fund	5.70%	8.75%
Artemis European Opportunities	7.81%	8.75%
JPM New Europe	-9.39%	-8.63%
Japanese Equities
GLG Japan CoreAlpha	-1.42%	-5.88%
Neptune Japan Opportunities Fund	14.76%	-5.88%
Asia Pacific Equities
First State Asia Pacific Leaders	-6.50%	-5.81%
Aberdeen Asia Pacific	-10.96%	-5.81%
Schroder Income Maximiser	-7.62%	-5.81%
Emerging Markets
Templeton Emerging markets	-10.03%	-8.63%
Somerset Gbl Emg Mkts A Acc GBP	-6.59%	-8.63%
Utilico Emerging Markets	-0.92%	-8.63%
Global / Specialist Equities
Scottish Mortgage Investment Trust plc	25.88%	2.02%
Standard Life Global Smaller Companies Fund	11.45%	2.02%
M&G Global Dividends Fund	-0.76%	2.02%
Specialist Equities
City Natural Resources High Yield Trust	3.21%	-7.82%
3i Infrastructure	3.63%	-4.37%
Baring Global Agriculture	-4.64%	-16.40%
AXA Framlington BioTech Fund	34.30%	7.25%

On the underperformance you will see that there are two sectors where the funds have not met their benchmarks – Europe and Asia. These figures are since 1 July 2013 and change from month to month, so although it shows short term trends we are more focused on the long term where this is not case.

In previous years these two sectors have outperformed and we don’t have concerns in Europe because a lot of the outperformance on the tracker has come from peripheral nations like Greece, and Portugal where active funds have less exposure. On Asia we are in the process of reviewing holdings we are aware that both First State and Aberdeen are looking to restrict future inflows of money and we are concerned that the size of the funds has hampered growth potential recently.

In summary

These benchmarks are a fair way for us to judge and equally enable us to determine whether a fund is outperforming an investable option (tracker ETF). We are comfortable that sometimes passives will outperform actives, this is a historic fact but equally through modelling the portfolios actives outperform in aggregate and in total over the vast majority of the scales.

 

NOTE: This is written in a personal capacity and reflects the view of the author. It does not necessarily reflect the view of LWM Consultants. The post has been checked and approved to ensure that it is both accurate and not misleading. However, this is a blog and the reader should accept that by its very nature many of the points are subjective and opinions of the author. This is not a recommendation to buy any product or service including any share or fund mentioned. Individuals wishing to buy any product or service as a result of this blog must seek advice or carry out their own research before making any decision, the author will not be held liable for decisions made as a result of this blog (particularly where no advice has been sought). Investors should also note that past performance is not a guide to future performance and investments can fall as well as rise.