The bespoke nature of private client management means that correctly gauging performance is virtuall...
The bespoke nature of private client management means that correctly gauging performance is virtually impossible. Individual risk profiles and objectives mean it is difficult to compare like with like and there are many shortcomings with the current indices.
Private clients want to know how their portfolios are faring, not just in absolute terms but also against the peer group and broader market. But those looking to determine whether their manager is delivering good, bad or mediocre performance have traditionally faced a problem: how can they best measure the performance of their portfolio?
There are certain indices available, but Graham Harrison, managing director at Asset Risk Consultants based in Guernsey, says these do not truly reflect private client portfolios nowadays because they do not incorporate alternative assets such as hedge funds or private equity.
This performance dilemma forms the basis of research conducted exclusively for International Investment by Incisive Research, which set out to determine how discretionary managers believe performance should best be measured.
As expected, most private client managers (45.8%) compared their performance against an index or composite of indices (see figure 1). Harrison believes there is little surprise in this, saying he would have expected this measure to be the industry standard.
However, he is encouraged that a fifth of managers claimed to compare against indices, cash and the peer group with equal importance. "It is good managers do not seem to be bound to a particular benchmark but are willing to think outside that constraint," he adds.
Gavin Haynes, a portfolio manager at Whitechurch Securities, which manages client assets worth at least £100,000, says his group uses cash as well as a composite of indices.
At Whitechurch, he says, the risk profile and objectives are established from the outset with the client. In the example of a client with a low risk profile, the likely goal would be cash plus 3%-4% and the return would be measured against cash to see if that is being achieved.
"We would also consider benchmarks based on what we consider to be fairly relevant benchmarks to that portfolio, to check we are managing it in line with our own expectations," he explains. "For instance, the IMA Cautious Managed or Balanced Managed sectors are probably most relevant to gauge a low risk portfolio against."
Considering timeframes, there is little surprise that more than half of respondents (54.2%) believed three years was the most important time period to use when comparing performance (see Figure 2). Although, 20.8% felt the longer five-year period was more appropriate.
Haynes says for most portfolios, especially where equities are concerned, investors should be looking on a five-year view. But he says for Whitechurch's own use, discrete year-on-year performance is used to ensure the portfolio manager is providing consistency of returns.
Harrison is amazed that 'since inception' scored so low at 8.3% of respondents. "Thinking about it from the private client point of view, what they care about is how they have done since they gave the manager their money," he says. "However, the industry has decided three years is a good number, it is not the investors that have decided that."
For instance, the CFA Institute in the US has deemed as one of its guidelines that performance should be looked at after three years and the Global Investment Performance Standards (Gips) is also three years.
According to the survey, the least tolerable risk when assessing performance of a portfolio was relative underperformance to an index or composite of indices, a view taken by 41.7%. However, Figure 3 also shows a wide number of participants (33.3%) believed absolute losses were the least tolerable risk.
Haynes agrees that absolute losses are least acceptable for the majority of clients, but adds that in a bull market, relative underperformance would be less tolerated.
He says: "Certainly in the 1990s people became so used to equity investment producing a positive return and absolute losses were something they considered could almost never happen. People were not concerned about them over any sort of medium term, up until 2000 when they really did occur.
"The prolonged bear market from 2000 to 2003 made investors reappraise their risk profile and that certainly made them realise losing money was a lot worse than underperformance of the index.
"In a rising market people were obsessed with relative returns on all levels, including institutional mandates. Now people have reappraised it in terms of absolute return and absolute risk and that is more what people tend to focus upon."
Although it is important to accurately measure performance, hardly any respondents thought the current benchmarks were particularly helpful. Figure 4 shows only 4.2% believed nothing more was needed, while the overwhelming majority (62.5%) felt the current benchmarks were moderately helpful, though noted there were some shortcomings.
Harrison says this shows the existing benchmarks are far from ideal. He adds: "Some people have found these benchmarks and just get on with it. However, others have given up trying to use them because the way they are running money is so far removed from the benchmarks that are available. Or with the way they run money they feel the benchmark is not an appropriate thing to use."
One of the shortcomings cited was that existing performance indicators did not accurately incorporate all asset classes being used, such as property, private equity and hedge funds. Figure 5 shows 79.2% felt that because niche areas such as these are not included in existing indices, they are not truly representative of portfolios today.
Haynes adds, however, that Whitechurch tends to keep things fairly simple, hardly branching into alternative assets, so there is no real demand as far as he is concerned for indices that incorporate these assets.
Though he believes with the advent of more absolute return funds, more expansive indices would be useful. He also says it would be interesting to see an absolute return benchmark for funds taking on different levels of risk.
Meanwhile, views on what was considered to be the peer group varied among private client managers. Figure 8 shows 34.8% considered there was no peer group at all, 30.4% felt other portfolios (competitors) were the main peer group and 26.1% believed similar funds were the best measurement.
The overwhelming majority of performance measurement was undertaken in-house, with Figure 9 showing 73.9% chose this route. The big in-house response numbers suggest the performance monitoring being undertaken is versus and index or cash only, rather than by an external independent provider.
Harrison says there is a huge potential market for a trusted body to gather peer group information on a no names basis and feed it back to the industry, so that private client managers actually understand what others are doing and they can see where they fit back into that.
Most respondents felt it was important to undertake some form of risk adjustment when comparing portfolio performance to a yardstick. Figure 10 shows 39.1% usually undertake risk adjustment while 21.7% always do.
However, Harrison is surprised that many groups claimed they always undertake risk adjustment when comparing their performance to a yardstick.
He explains: "I have rarely, if ever, seen a report from an investment manager when they have incorporated such risk adjustment. Maybe what they mean is they have done it internally. "
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