US dollar-denominated indices reveal a significant disparity between the performance delivered to discretionary private clients by different investment managers, which highlights the need to ensure manager selection is made to measure, says Graham Harrison of Asset Risk Consultants
Following on from the success of the Sterling Private Client Indices, a US dollar-denominated PCI series was launched in March with 20 founder data contributors providing historical performance data for the four-year period commencing December 2003. As with their sterling counterparts, the indices are based on real performance numbers delivered to discretionary private clients by participating investment managers.
The indices provide an accurate reflection of the actual returns that a private client should expect for a given risk appetite. They leave investment managers free to use any and all investment strategies, vehicles and structures in the pursuit of the maximum return per unit of risk.
The US Dollar PCI series, like its sterling equivalent, comprises four published indices based on the following risk categories relative to the equity market:
- Arc Cautious Index 0-40%
- Arc Balanced Asset Index 40-60%
- Arc Steady Growth Index 60-80%
- Arc Equity Risk Index >80%
These indices are intended for use by private investors as a performance yardstick against which to compare the returns delivered by their portfolio manager. By definition, it would be expected that half of all US dollar-denominated private client portfolios will have exceeded the indices and half will have underperformed.
For those private investors who are unsure which risk category their portfolio falls into, a simple rule of thumb is to take the percentage invested in equity markets as an indication of the relative risk to world equity markets. Thus, for example, if a portfolio has between 60% and 80% invested in equities it should be compared with the Steady Growth PCI.
Table 1 below sets out the performance for each of the four US Dollar PCI risk categories over the past four discrete years and the performance for the first three months of 2008.
The results show that, in US dollar terms, investment returns have been very healthy over each of the past four calendar years and that investors have been rewarded for taking risk.However, the first quarter of 2008 has been extremely tough, with losses being recorded by even the most defensive of the four PCI risk categories.
To put these losses into context, this is the first quarter since Q2 2004 that losses have been recorded across all four PCI risk categories. The drawdown chart below shows the severity of these losses in the context of previous market setbacks.
As can be seen, there have been several financial market setbacks since 2003 but, even for the Equity Risk PCI category, the level of drawdown did not exceed 4% until 2008. By contrast, at the end of March 2008, many investors would have been looking at a double-digit drawdown and the likelihood of an expected recovery period of several quarters.
Another way of placing the first quarter of 2008 into perspective is to plot 12-month rolling returns for each of the four PCI categories. As Chart 2 illustrates, for the first time in over five years, investors would be looking at 12-month returns below those from cash. Even with the bounce in financial markets experienced thus far in the second quarter, it is likely that 12-month rolling returns will go negative at some point in 2008, causing many investors to reassess their risk appetite and the performance of their discretionary manager.
As this happens, the need for investors to be able to place the performance of their portfolio into a peer-group context will become paramount. The automatic reaction of many private investors when faced with losses is to seek to change the manager rather than consider the relative performance of the manager versus their peers. The ARC PCI series are intended to aid investors in making more informed choices and hopefully avoid jumping out of the proverbial frying pan and into the fire.
With this in mind, when examining the results in more detail, an interesting fact emerges: the performance differential between discretionary managers is surprisingly wide.
With the majority of discretionary managers adopting a multi-asset class approach to building portfolios, it is not so surprising that during periods of financial market dislocation, performance differentials have become wider. However, it is not in the typical multi-asset class mandates where the widest performance differentials have occurred, but predominantly in portfolios investing in equities.
Table 2 below presents the return dispersion for the three-year period ended March 2008. In the two middle-risk PCI categories (Balanced Asset and Steady Growth), the performance differential between top and bottom quartile was in the region of 7.5%. However, for the Equity Risk PCI category, the performance differential widens out to over 14%. While a top manager would have delivered their clients in excess of 40% over the last three years, a bottom-quartile manager would have recorded a gain of less than 25% over the same period.
Conventional wisdom states that strategic asset class selection is responsible for anything from 70% to 80% of returns. Whilst this may be true over longer periods, our analysis suggests that over the past three years, manager ability has been equally important.
Consider Table 3. The return from sterling cash was 16.4% over the period. Thus the average excess return over cash added by discretionary managers in each of the four PCI risk categories can be calculated by taking the three-year return and deducting the cash return. The difference is the effect of adopting different asset allocations (or risk budgets).
For the lowest PCI risk category, manager ability seems to dominate as the most important determinant of excess return. The three-year excess return over cash was just 1.4%, whereas the performance differential between a top and a bottom-quartile manager was 6.2%.
For the other three PCI risk categories, manager ability could be said to have determined around half of the performance differential, with the risk decision being responsible for the other half. In other words, the three-year excess return over cash is roughly the same as the differential in performance between a top and a bottom-quartile manager.
In conclusion, the launch of the US Dollar PCI series allowed us to drill down into the value being added by discretionary managers for US dollar-denominated private clients. Examining actual portfolio returns over the past three years has revealed there is a significant return disparity between the best and worst managers. While strategic asset allocation clearly matters, getting manager selection right is far from a trivial adjunct.
- Graham Harrison is managing director of Asset Risk Consultants.
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