Ten key points on performance benchmarks

A wealth manager can help you vastly improve your financial situation through using clever financial planning techniques to make tax savings, but most people will be looking to the professionals to maximise their investment returns. So, how do you tell which firm is likely to make you the most money?

Although past performance is no guarantee of future gains, it is often a strong indicator. If a wealth manager can demonstrate that they’ve achieved good results for clients like you, over a significant period of time, and in a variety of market environments, then they are likely to be good bet for managing your money.

It certainly seems that investors could stand to take a closer look at performance. Research by Seven Investment Management (7IM) shows that only 50% of High Net Worth Individuals weigh up investment performance when selecting a wealth manager and just 40% use market performance or a financial benchmark to do so.

One of our core aims is to enable potential clients to compare wealth managers in an easy but meaningful way. Then, having a handle on the hard metrics, you can identify the managers you click with best.

So, what does “good” mean in investment track records?

In short, what you’re looking for is “outperformance”, meaning the degree to which the wealth manager delivered gains in excess of general market rises or those seen for an appropriate benchmark index.

The key phrase there, of course, is “appropriate benchmark”. As experts from our panel of institutions explain, understanding how benchmarks work is vital to reading investment performance and comparing wealth managers’ track records effectively.

Best-known doesn’t mean best

When we speak to investors, we find that many have a well-known stock market index such as the FTSE 100 in mind as a basic benchmark for the investment performance they should be seeing. (The FTSE 100 is an index composed of the 100 largest companies by market capitalisation listed on the London Stock Exchange). 

“The FTSE 100 is chosen because it’s a number related to investments that people can easily track and is very publicly available,” observes Joe Cooper, Senior Performance Specialist at Seven Investment Management. “Many also use it as a proxy for the UK economy.”

However, there are several reasons this may not be the best approach.

Be sure the benchmark is representative

The FTSE 100’s usefulness as a standalone benchmark for most investor portfolios is questionable, warns Colin MacKenzie, Director, Investment Management at Arbuthnot Latham & Co., Limited. “Most investors invest globally in a variety of assets, with only a part of their portfolio invested in the UK and only part of that directly in shares of, or in funds invested in, the top 100 companies,” he says.

 “We believe that clients should be looking beyond the FTSE 100 as it is typically not suitable to meet an investor’s goals (i.e. their objectives and constraints),” says Cooper. “Most investors’ risk appetite means they wouldn’t be able to stay invested through a 45% drawdown like we saw in the 2008 Global Financial Crisis, for example.”

Even opting for a global index such as the MSCI All Country World is unlikely to be appropriate because few people will have all their portfolio invested in equities due to them being riskier than other types of assets.

As MacKenzie explains, benchmarks should reflect the actual structure of a portfolio, which itself is a product of its investment objectives and the client’s desired level of risk.

“Investors must first ensure they are comparing apples to apples and looking at things that reflect their portfolio,” adds Christian Armbruester, Chief Executive of Blu Family Office. “The success of any benchmark is whether it accurately covers your investment portfolio (think bonds versus equities, for instance) and how relevant it is in giving the investor a proxy for what else one could have done with the money.”

Reflect on risk-reward trade-offs (and your net gains)

As discussed, comparing like with like invariably calls for far more precision than reaching for the best-known market index. Different asset classes – and sub-asset classes – can have wildly different risk-return profiles, even where at first glance they might appear quite similar.

Returning to our first example, Armbruester warns that using the FTSE 100 is meaningless for those investing in small growth companies.  “The risk parameters are very different for small versus large companies, and also in terms of the liquidity in the shares,” he says.

Investors need to have a really accurate view of the risk each element of their portfolio represents. Moreover, Armbruester urges investors to make sure they are getting rewarded for the underlying risk they are taking on, and that the wealth manager is implementing investment strategies in the most efficient manner possible. “If you pay someone to outperform the market, 85% of the risk is driven by market risk and you should never pay a performance fee for that, when you can buy it for 0.10% in an index fund or Exchange-Traded Fund,” he says.

Examine regional exposure

Another important consideration is regional exposure. Understanding the regions whose fortunes your portfolio is most closely tied to is a vital part of understanding your exposure to investment risk.

Returning to the FTSE 100 example, you will find that large companies’ revenue streams tend to be more internationally diversified than more domestically-focused smaller companies – despite the fact that both may be based in the UK.

Weighing the interwoven risks of an investment portfolio is one of the key skills of a wealth manager. A good one will help immensely in filtering out the “noise” of the 24/7 news agenda, but a good understanding of geopolitical/country risk will help all investors know when not to be alarmed. 

Take a view on volatility

As Armbruester notes, volatility is important because it tells you how much an asset has moved over a specified period of time and how that compares to other assets (although it is unknown whether the assets will continue to behave the same way going forward). 

However, this is why volatility can also be very misleading, as depending on which time horizon you look at, the measure of performance or the quality of the returns can be very different.

“Risk is very important – it’s why we have a team focused on risk measures that is independent from the investment team – although that doesn’t necessarily equate to volatility,” says Cooper.

“We often see historical volatility used as a proxy for risk, but this can be far too simplistic. Direct property holdings, for example, are priced infrequently and this would show up as low volatility. However, clearly, this doesn’t reflect the true risk of the investment.”

Attend to the blend

Many wealth managers take an outcome-focused approach to benchmarking, useful for when clients have certain expenditures to meet over a number of years or have beating inflation front of mind.

Cooper here flags the targeted returns that Seven Investment Management are aiming to achieve for their clients. Depending on each client’s risk-profile, money is managed for their multi asset portfolio ranges to aim to achieve a pre-agreed percentage return over the long term.

MacKenzie, meanwhile, observes that clients investing in Arbuthnot Latham’s “bottom-up” thematic portfolios would have as their benchmark the Consumer Price Index, plus 1%, 2% or 3% (depending on their exact objectives and investment mandate).

The diverse and highly internationalised universe of investments available has also led to multi-asset benchmarks being increasingly used today. This means that wealth managers might deploy composite benchmarks which blend several indices to more accurately represent a portfolio’s relevant performance.

You may also find that potential wealth managers reference proprietary benchmarks such as the MSCI WMA Private Investor Index Series or ARC Private Client Indices. These show performance across the industry for portfolios categorised as “cautious”, “balanced” or “growth” orientated.

Be time-sensitive

The ultimate aim of benchmarking is to be able to discern the best performing money manager relative to their peer group. Here, it is important that the firm be able to demonstrate robust performance over a sustained period and in a variety of market conditions.

As Armbruester points out, “the years since 2009 are particularly difficult to benchmark as everything has gone up, making it hard to distinguish talent from luck”.

Again, a wealth manager’s ability to explain periods of out- (or under-) performance is crucial. “It’s good to try to understand how the fund or firm performed in different environments or specific periods and why they performed that way to see if you can find the good decision-makers,” says Cooper.

Consider building your own

Many of our users are newcomers to professional wealth management, while others are experienced clients looking for a better partnership. Both, however, want to be able to make objective assessments of the wealth managers competing for their business and benchmarks can really help underpin this understanding. Here, as so often, investing is as much an art as it is a science

“First, it’s important to understand the objectives (e.g. the return they’d like to achieve) and the constraints (e.g. risk, cost, asset class etc.),” says Cooper. “Then they should try to compare the performance against those objectives and constraints, but should not try to put too much significance on short-term numbers (e.g. three years or less).”

Those getting really granular on investment track records may wish to come up with their own benchmarks so that they can then compare all the managers against the same standards.

“For equities, use any broad index (such as the MSCI All Country World) and align the currency exposure to your desired investment strategy. If you invest in specific regions, sectors or size, then pick the corresponding index to adjust your risk factors,” explains Armbruester. “For bonds, take the local government index and again adjust to the duration to your desired risk level.  For everything else, it is quite simply if the returns are greater than zero and didn’t stem from bond or equity risk.”

Benchmarking best practice

While a blended (and possibly quite complex) benchmark may be more accurate, our experts caution that certain standards must always be met to ensure performance is presented in a sensible way.

In this spirit, Cooper explains that 7IM takes a “SAMURAI” approach to benchmarking since, as an acronym, it forms a good checklist in which “the Japanese warrior of old becomes: Specified in advance; Appropriate; Measurable; Unambiguous; Reflective; Accountable, and Investable.”

Investors must also resist becoming over-focused on complex performance benchmarks, or looking at periods too short.

“A longer track record – ideally 10 years or more – makes comparing performance by numbers more significant,” Cooper continues. “Luck and noise will likely be a factor over the short term, and so will require more of a qualitative exercise.”

Understand the underlying thinking

As readers will have gathered, comparing the investment track records of wealth managers can be complex, particularly when differing investment processes mean like-for-like comparisons of portfolios are a challenge.

Instead, we would advise that you use benchmark data as the foundation of your understanding of a firm’s prowess and a starting point for further discussion. Understanding a wealth manager’s thought-process should be your aim.

“What we believe is that it’s useful to try to understand the decisions managers have been taking and how this has impacted their short-term performance,” Cooper concludes. “Lots of good decisions have bad outcomes and vice versa, however, making good decisions should lead to good outcomes – but only over the long term.”

Summary

Although monetary gains have been the focus of this guide, you may also want to think about returns in a broader sense, to recognise that owning an asset can generate both financial and emotional returns. This may be the enjoyment of passion investments or, equally, the satisfaction of investing in ways that benefit society or the environment in the way you want (known as impact investing).

“Art collectors know they may get a financial return from their collection, but know they will get an emotional return. In the same way, investors can capture an emotional return across other investments too,” observes James Lawson, Co-Founder of Tribe Impact Capital. “Wealth is a means, not an end. In this way, if you intend to use just £1 of your wealth to do some good, you’d be better off by doing good through the investment process, rather than using the proceeds.”

As he concludes, understanding why you are investing is key. If you are interested in the stories of your investments, you will have greater comfort along the investment journey. This makes you a better investor, less prone to common errors like selling at troughs and buying at peaks.

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