Choosing the Right Benchmark

A benchmark should answer a simple question: is the portfolio achieving the objective for which it was established, within the agreed level of risk? A poorly chosen benchmark can instead create confusion and encourage the wrong decisions.

What Most Clients are Trying to Do

In my experience, most private-client objectives ultimately concern preserving or increasing purchasing power over a particular period. I would therefore usually judge a portfolio against an inflation-linked target, such as the Consumer Prices Index (CPI) plus an agreed margin, measured over the client’s own time horizon.

If the portfolio keeps pace with that target and the future expenditure can be met, the objective has been achieved. How a peer group or market index performed over the same period is then of secondary importance.  Conversely, if the portfolio falls short of the client’s objective, strong relative performance may still be disappointing.

Over a year or two, an inflation-linked target can be missed because of a sudden increase in inflation that no realistically constructed portfolio could be expected to match immediately (2022 being the most recent example when a spike in inflation caused equities and bonds to fall together).  It also fails to identify whether the manager’s decisions added value, and the margin above inflation also needs to be realistic for the level of risk the client has chosen.

When a Relative Benchmark is the Better Choice

For some clients, the relevant question is whether the portfolio did better than the alternative.  A client comparing managers or assessing whether active decisions justify their fees may be better served by a composite market index or a peer group such as the Asset Risk Consultants (ARC) Private Client Indices. These can measure relative skill well but are less useful in determining whether the client’s own objective is on course.  Any comparison should also be genuinely like for like: a global value manager and a US growth manager are pursuing different objectives and should not be judged as though their portfolios were interchangeable.

Changing the Benchmark

A benchmark should normally change only when the client’s objective changes or when the original measure is shown to have been unsuitable.  Underperformance against an appropriate benchmark is a reason to investigate the result, not to change the yardstick.

Questions Worth Asking

• What is this money for, and does the benchmark measure that?

• Over what period will performance be judged, and was that agreed in advance?

• If the portfolio meets its objective but trails an index, is that a problem?

CDAJ

Risk Warning & Disclaimer

This article is provided for general information purposes only and is not intended to constitute investment advice, investment research, or a personal recommendation. It does not take into account the investment objectives, financial situation, or particular needs of any individual or entity.

The views expressed are those of the author as at the date of publication and are subject to change without notice. The material is the original work of the author. It may not be copied, reproduced, distributed or presented as the work of another person without his prior written consent.

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Ptarmigan Capital Limited is an employee-owned investment management firm providing discretionary investment management services to private clients, trusts, charities, and family offices. This article is intended to explain the firm’s perspective on bespoke investment management and the factors some clients consider when choosing such an approach. It does not relate to any specific investment product or strategy.

Ptarmigan Capital Limited is authorised and regulated by the Financial Conduct Authority (FRN 940407). Registered in England and Wales (Company No. 12715470). Registered office: 17 Cavendish Square, London W1G 0PH.