Portfolio Evaluation: Benchmarking for Success
Although portfolio evaluation is the last step in the portfolio management process, it is by no means the least important. On the contrary, proper performance measurement, attribution, and appraisal can enhance the probability of success for the entire investment process. Improper evaluation, on the other hand, can directly create some of the often-criticized issues in the investment industry. (For example, Nobel laureate Myron Scholes believes benchmark and tracking error can derail an investment process. I discussed what this meant with him in detail last week in Tokyo. Stay tuned for my write-up.)
In this fourth installment in the multi-asset strategies series, we discuss three important issues in portfolio evaluation and some institutional investors’ best practices.
1. How should we deal with the conflict between long-term investment goals and short-term evaluation cycles?
Many investment managers follow investment processes that are inherently long term. For example, value strategies often take a full market cycle to bear fruit. If investors hold such managers to a quarterly evaluation cycle, conflicts often arise. Understandably such managers’ returns may end up in the bottom quartile in a quarter. Investors expecting otherwise will be disappointed. Worse, if the managers are forced to modify their process and deliver more consistent returns, they might be become disoriented.
Smart investors have come up with different approaches to deal with this potential conflict.
According to Chiew Kit Tham, managing director at GIC, his firm measures its own performance over a 20-year horizon. He does not think the 65% equities and 35% bond reference portfolio is appropriate for use as a short-term return yard stick but more as a risk measure. He admits that external active managers have a much tighter leash, although private market managers are allowed more time to demonstrate their competence.
The success of the Thai GPF fund is judged by its performance relative to consumer price index (CPI) over 10 years, says Nachcha Protpakorn, deputy secretary general of the Thai Government Pension Fund (GPF). Each year they also measure the portfolio’s performance against a global benchmark reset each year opportunistically.
My Take: Measuring a multi-asset strategy’s long-term performance over inflation and short-term volatility relative to a simple equity plus fixed income reference portfolio seems to help motivate managers to resolve the conflict between long-term goals and short-term evaluation cycles.
2. Should performance evaluation be quantitative or qualitative?
Various formulas come to mind when people talk about performance evaluation. The standard attribution formula is an integral part of the CFA® curriculum. GIC also uses regression analysis over various periods to measure return drivers in their portfolio, such as equity, emerging markets, and credit. The team will then adjust portfolio exposures accordingly where necessary.
Richard Brandweiner, CFA, CIO of First State Super, prefers using the expert panel approach. His team focuses on the economic rationale and systematic exposures (i.e., factors) in their analysis. They look at each manager and debate what the key contributing factors are to the portfolio’s performance. Brandweiner limits the discussion to three exposures in each case so as not to over-engineer the outcome.
For the overall portfolio, Richard crosschecks the return/risk exposure and the probability of achieving these.
My Take: The key to performance evaluation is understanding the return drivers. There is no inherent conflict between the qualitative and quantitative approach. In fact, I believe they are complementary. The quantitative approach can make the assessment more objective, while the qualitative approach might help illuminate the big picture and deliver a sanity check. A good quantitative model requires good intuition while good qualitative analysis can always benefit from the validation that a quantitative assessment of the same portfolio provides.
3. Should performance for active and passive portfolios be measured differently?
Tomas Franzén, chief investment strategist at Second Swedish National Pension Fund – AP2, thinks so. AP2 has developed tilted indices for portfolios they manage in-house using an active quantitative process. They reserve the market-weighted indices for use in evaluating the passive funds.
My Take: Using a tilted index is the natural evolution as our understanding of return drivers improves over time. A value manager will increasingly be asked to outperform the value index and not just the broad market as investors are educated on the impact of value and other factors on portfolio performance.
An important caveat is that we need not lose sight of the long-term goal (total return) of investing when drilling down to drivers of active returns. Total returns are apparently more relevant for asset owners and average investors while understanding active return drivers is of critical importance in manager selection. Only a holistic review provides the full picture.
In summary, portfolio evaluation can be much more than just producing a score card. There are various approaches investors can take in the process to enhance portfolio performance.
This is the fourth article in the multi-asset strategies series. The first three posts were: “Multi-Asset Strategies: A Primer,” “Three Key Decisions in Formulating an Asset Allocation Strategy,” and “An Advance in Portfolio Construction.”
For more in-depth coverage of these topics, Multi-Asset Strategies: The Future of Investment Management is available to CFA Institute members.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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