With the accurate comparison of the performance of private client portfolios proving a complicated task, it is clear the industry needs to rethink its approach
It is human nature to want to know who is the best at anything and everything. The variety and sheer number of entries in the Guinness World Records book provides conclusive proof of this. Close behind the desire to know who is the best, is the question of who is above and who is below average. Nobody likes to be below average, which is a problem given that, by definition, around half of any sample being measured will fall into this category.
The investment arena is certainly no exception to the tyranny of statistics. Investors want to know how they are doing, not just in monetary terms but also versus the market. However, private clients looking to assess whether the performance of their investment manager has been good, bad or indifferent have historically faced a problem. What is the best performance metric against which to measure their portfolio?
There are three broad ways in which performance can be assessed - benchmark, peer group and opportunity set - to name but a few.
The most common way to measure performance is to establish a benchmark at the outset of a portfolio, against which future performance will be measured. This might be a single index, for example the FTSE World Equity index for a global equity portfolio. More usually, the benchmark is a composite of financial market indices including equities, bonds and cash in appropriate proportions.
The main advantages of using a basket of financial indices as the basis for assessing portfolio performance are simplicity and transparency. However, there are several drawbacks: indices are costless, the 'neutral' asset allocation is pre-defined by the weightings applied to each contributing index and it is difficult to identify the best indices to use to encompass the wide range of asset classes now available.
When examining the performance of funds, peer grouping is the most popular approach to placing performance into context. Fund analysis software, such as Lipper Hindsight, Morningstar and SAS Profiler, allows funds to be grouped into appropriate universes. Then performance can be ranked or divided into quartiles, deciles or even percentiles.
Private investors are no different. They would like to be able to place the performance of their portfolio into context by comparing it with that of similar portfolios.
The main advantage of comparing performance to a peer group is that an investor can see where they lie compared with the average and all the contributors to that average. However, for private clients there is currently an insurmountable problem - there is no easy way of knowing how their fellow investors have actually performed.
While peer grouping allows the performance of portfolios with similar investment objectives and guidelines to be compared, analysis of the opportunity set allows performance to be considered in the light of the range of investment decisions that were available to the investment manager under the agreed guidelines.
Consider two managers: the first has guidelines that fix the equity exposure at 50%; the second has guidelines that allow equities to be held in the range of 25% to 75%. The first manager has a far more limited ability to take advantage of a strong run in equity markets and equally cannot easily protect capital in the event of a downturn. The opportunity set for the portfolio run by the second manager is clearly wider, but this flexibility is a double-edged sword - bringing the chance of outperformance but also the possibility of underperformance.
Most private clients would like to see their investment managers fully invested during equity upswings and in cash during market corrections. Conventional performance measurement approaches do not adjust for changes in risk appetite. However, to give an idea of the opportunity set available, managers often compare portfolio performance against a variety of financial market indices.
The private banking industry seems to have realised that a fresh approach to measuring private client portfolio performance is needed. The existing indices, such as the Association of Private Client Investment Managers and Stockbrokers (Apcims), do not reflect the multi-asset class approach that has become the norm among managers, incorporating not just equities, bonds and cash but also hedge funds, property, commodities, structured products, currency overlays and private equity.
Several new initiatives have sought to solve this dilemma by producing indices that reflect the actual asset allocations being used by private banks. However, even with asset allocation simulation techniques to calculate a range of potential returns for any particular investment strategy, the resultant indices are not based on real outcomes of actual private client portfolios.
As the private banking industry moves away from static asset allocation benchmarks to a more risk-based approach, the challenge is for a set of indices to be designed for benchmarking performance that meet the desires of both the investment managers and clients. The following characteristics would be desirable:
l Cover the main reference currencies and risk tolerance levels.
l Provide sufficient back-data for meaningful historical comparisons.
l Adopt a risk-based approach rather than use a static asset allocation.
l Take account of the multiple asset classes incorporated in private client portfolios.
l Allow performance to be placed into a decile or percentile ranking.
l Incorporate real performance numbers of actual private client portfolios.
This may seem an ambitious goal given the historic aura of secrecy surrounding private banking. However, it is surely time for private clients to be able to place their portfolio performance into perspective.
What is needed is for the techniques developed in the institutional investment and mutual fund industries to be modified to meet the unique requirements and circumstances of the private client investment world. key points
There are three main performance measurements - benchmarking, peer grouping and opportunity set
Advantage of benchmarking is simplicity and transparancy; peer grouping shows how a fund compares with its rivals; Opportunity set accounts for the range of investment decisions available
A fresh approach to measuring private client portfolio performance is needed
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