Why Goal Based Benchmarks make sense for Private Clients
Historical Perspective
Benchmarking has been one of the hottest debating topics in the fund management industry for nearly forty years. The initial assumption was that clients needed something in order to measure the performance of their investment manager. The reasoning was “what could I reasonably expect my investment manager to produce for me in the prevailing market conditions?” This was borne out of the institutional pension fund industry and the result of the comparison allowed trustees and their advisers to be seen to be carrying out their duties effectively. An underperforming manager would be removed and a comparison of performance versus a benchmark allowed trustees to select a new and hopefully better performing fund manager.
The interesting aspect of this was that these performance characteristics, even on a manager consistently outperforming the benchmark index, may bear no comparison to the performance needs of the underlying pension fund. As a result, and as many schemes soon found to their sponsoring company’s cost, during periods when capital markets languished with negative returns many pension schemes reported sizeable funding deficits despite employing an investment manager who was out performing an index and assumed that they were doing a good job. By one measure, relative performance, they were doing what they were mandated to do but on the measure of protecting the scheme’s solvency they clearly were falling short.
Over time, the institutional industry evolved ever more complex benchmark indices that were supposed to overcome these shortcomings. In practice they rarely achieved what the trustees and the pension fund sponsors were looking for because all these indices had one fatal flaw. All of the indices were based on market indices with their attendant volatility characteristics.
Private client benchmarking becomes institutionalised
Private clients had tended to be measured on a rather different basis. Often the requirement would be to achieve the highest return possible from a combination of different assets with the tacit expectation that the fund manager would be able to switch to cash before equities or bonds fell. Here we had the nub of the problem. Fund managers often found it difficult to sell because if they got it wrong, which they invariably did, and equities / bonds continued to rise then they would underperform and ultimately lose their client.
As a result, the private client investment management industry became more institutionalised in the final decade of the last century. The drive of these larger managers was to adopt a similar benchmarking system to the pension fund industry. Out of this quest, the Association of Private Client Investment Managers and Stockbrokers (APCIMS) was established in the 1990s. Fairly soon benchmark indices were constructed to provide a measure of the typical performance of how a cautious (income) and balanced and more aggressive (growth) portfolio should be. These quickly became the templates for many private client fund managers allowing them to claim relative performance success (or not) compared to these indices. In order for these investment managers to protect their reputations it became the industry standard to take the proportions of the APCIMS indices and, for example, for a client deemed to have a balanced requirement to deviate only slightly from the implied asset allocation of the index. In a sense, the investment manager has now abdicated the responsibility for asset allocation to APCIMS in order to concentrate on achieving positive stock selection for their clients.
Why Goal Setting is important for Private Clients
Goal setting is important as it provides a clear focus on what the investment is trying to achieve. When we consider a client’s goals it becomes clear that market-based benchmarks are not sufficient. For example, as the credit crisis of 2007/2008 began to unfold we saw a high degree of correlation of the assets used in traditional market benchmark portfolios. Quite simply the assets used all lost value and so did client portfolios measured against these benchmarks.
You are paying your investment manager to outperform your benchmark. Consider a manager benchmarking the APCIMS Balanced Index between October 2007 and March 2009. The Index dropped almost 30%. Therefore, a fund manager whose balanced portfolios fell by 28% would be able to claim a successful outcome. Few clients are likely to agree; after all the things they want to achieve with their wealth will still cost the same.
When you examine these statements it is, perhaps, not surprising that the wealth management industry is beset by a client base that feels regularly disappointed by the investment performance of their fund manager.
Let’s consider the situation of a fairly typical private client. They will have worked hard to build their savings over a number of years. They may be considering tax planning for the benefit of their children, looking to achieve a regular income from a SIPP portfolio when they retire or they may even be seeking to acquire an aspirational asset, such as a second home or yacht at some time in the future. Here is the problem. The client does not expect the value of their wealth to decline-ever. They expect steady returns over time; their expectations are both linear and rising.
Interestingly, these different goals that they may have set for their wealth to achieve may have very different return requirements and, importantly, volatility tolerances. For example, a client wishing to maintain a real income stream from a SIPP may accept a lower long term return for a higher level of certainty of maintaining a capital ‘pot’ to keep paying an acceptable level of income into retirement. This will require managing the volatility of the portfolio in order to achieve the client’s objective. For a client looking to acquire an asset such as a yacht, the desire may be to put as little initial capital into the portfolio as possible and they may have much more flexibility in the time period before they sail around the world! In other words, they will be looking for a higher return and also be prepared to weather a higher level of periodic volatility.
The first challenge for the investment manager is to identify the characteristics of these different aspirations or goals. Once identified, these then become the client’s benchmark. This can then be measured in terms of both the expected annual average return and the volatility of the portfolio constructed to achieve this. Notice that there is not a single market index implied by this statement. The goal set by the client is the objective and hence the benchmark for the fund manager.
The final challenge for the fund manager is to devise a way of investing in order to achieve these twin aims. To succeed in meeting this challenging objective a fund manager will need to have a sufficiently wide enough range of investment opportunities to get the benefit of real diversification. The investment manager will need the appropriate resources to secure access to strategies that may not be dependant on movements in the underlying traditional asset classes for their success.
The problem here is that the investment processes that support many fund managers are linked to attempting to produce a relative return based on indices. In order to change this approach the fund manager will need to alter their investment process and invest in the necessary personnel and systems that will allow them to construct portfolios benchmarked to an absolute return based on their clients’ goals. With investment management profitability often under considerable pressure following the exceptional volatility in the financial system over the last three years it may be some time before the industry has sufficient confidence to make the significant investment that this will entail.
In the meantime, goal setting benchmarks and the ability to invest to achieve these effectively will be confined to a small coterie of investment organisations who have made such an investment in skills and systems.
Trevor Forbes,
Head of Investment,
Standard Life Wealth