Common Investment Benchmarks

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Blaise Chase
5 years ago
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1 Common Investment Benchmarks Investors can select from a wide variety of ready made financial benchmarks for their investment portfolios. An appropriate benchmark should reflect your actual portfolio as closely as possible. An apples to apples comparison. The chosen benchmark should also be easy to calculate for comparative purposes. If you cannot get access to timely data, even the best of benchmarks will be of little practical value. Today we shall look at common benchmarks used by many investors. Positive Nominal Return Think of this as a zero return benchmark. The goal is to obtain a positive nominal return for the period. Anything that does not incur a loss during the period is good. Probably best for low risk individuals who invest primarily in cash equivalents or low risk fixed income assets. Positive Real Return Real return reflects the impact of inflation on your performance. Nominal return does not. To calculate real return you must subtract the inflation rate from the nominal rate of return. Perhaps you invest $1000. At the end of one year you receive $1100. The nominal return on the investment is $100 or 10%. Not bad against a nominal benchmark return of 0%. But what if inflation for the year was 15%?

2 In rough terms, let us say that your $1000 buys a specific basket of goods and services on January 1. That same basket at 15% inflation will cost $1150 on December 31. Although your 10% nominal return sounds good, with 15% inflation your purchasing power is actually eroded over the course of the year. Your real rate of return is actually -5%. You would have been better off not investing the money, instead spending the money on goods and services. That is the impact of inflation. Like nominal positive returns, real returns as a benchmark is probably best for low risk investors whose portfolios are heavy on cash equivalents and fixed income. Given the potentially debilitating effect of inflation on interest and dividend income, I suggest using real returns for benchmarks over nominal ones. Risk-Free Rate of Return A good benchmark in general terms. The risk-free rate is the return you would earn on an investment with no risk. Assets that are fully backed by federal government guarantees are the closest thing to riskless, although this may become less true as more governments get into serious debt problems. U.S. Treasury bills is one such risk-free asset. The advantage of this benchmark is that it reflects your portfolio return if it assumed no risk. But, a diversified portfolio will have some level of risk. And, as we saw with our discussion of the risk-return relationship, the greater the risk assumed, the higher the desired return. By setting a benchmark for assets with no risk, you can easily see if your riskier portfolio generates extra returns to account for the added risk.

3 The risk-free rate of return can be used as a benchmark for any portfolio. The lower the risk of the portfolio, the more relevant it will be though. The higher the portfolio risk, the less relevant. This is because you expect a higher risk portfolio to achieve greater returns over time than a risk-free asset. But how much greater the return is appropriate? If the risk-free rate is 4%, should a high risk portfolio be expected to return 10%? 15%? 20%? I have no idea. The higher the portfolio risk, the more it becomes an apples to oranges situation when comparing a higher risk portfolio to the riskfree rate. That is a problem with using 0% or the risk-free rates as benchmarks. Arbitrary Nominal or Real Returns A benchmark of 0%, in either real or nominal terms, may not be an appropriate number. One reason is that your portfolio should be seeking higher returns than 0% anyway. So a null return might not make any sense (apples to oranges). A second is that even if you beat the benchmark consistently (say averaging 1% per annum), you may not generate enough wealth over time to retire comfortably. Because of this, some investors choose arbitrary benchmarks. Either in nominal or real terms. Often there is some rationale behind the number. 10% is always a nice round number. Maybe equities averaged 12% over the last decade, so that seems like a reasonable target. There are many reasons for arriving at a benchmark. Some make more sense than others.

4 For example, you intend to invest $12,500 at the start of each year for 25 years and want to amass $1 million. To do so, you need to earn over 8% per annum each year. So that may be a relevant target. Arbitrary return benchmarks may be suitable for balanced (mix of cash, fixed income, and equities), some fixed income, and equity. Summary These benchmarks are used by many investors. They are easy to identify and performance data is plentiful. These common benchmarks give some good general information. They may show if your portfolio achieved positive returns in either nominal or real terms? Or if it outperforms a static number chosen based on personal reasons? Perhaps the risk-free rate. Perhaps a return required to meet specific goals. But these benchmarks often make apples to apples comparisons difficult. They may not adequately reflect the composition and risk of your own portfolio. And if the informational value is weak, it makes the use of that benchmark less relevant. While these benchmarks are useful in a general sense, I suggest you look at other options. We will look at more practical benchmarks next time.

5 Fund Performance is a Relative Concept Investment returns are difficult to assess in isolation. What does it mean if an asset has an annual return of 10%? Is it good, bad, or average? To answer that, results must always be placed in context to be of any informative value. That brings us to the topic of relative performance. We looked at this concept a while back in Assessing Investment Returns. For numbers to make sense, they always need to be compared to something. Historic Performance Depending on the jurisdiction, funds may be required to present performance data for multiple periods. In the U.S., disclosure is required for the following return periods: year-to-date; 1 year; 3 years; 5 years; 10 years; since inception. Do not be mesmerized by the year-to-date or latest one year returns. Anybody can experience success in the short-run. Luck can play a big role. Also, management tricks can be used to make current year returns look good. We will look at common fund manipulations later. Of course, luck and tricks can go both ways. They can also hurt performance.

6 You need to go back farther in time than one year returns. The longer the return data, the less chance that luck or portfolio manipulations will distort performance. Throughout this post, we will use a fictional mutual fund to illustrate the points. ABC Canadian Equity Small-Cap Fund had returns of 12% for 1 year, 10% annually over 3 years, and 11% annually over 5 years. In comparing historic results, that suggests a consistency in fund returns. However, if ABC returned 45% over 1 year, but still 10% annually over 3 years and 11% annually over 5 years, it suggests potential issues. This is a large variability of returns between years. There are a multitude of reasons for the high variance. Perhaps performance reflected changes in the economy or markets as a whole. It may suggest a modification in investment tactics or a change in fund management. Perhaps the fund moved to increase its portfolio risk over previous periods. When there is a large change in returns, you need to determine why. There might be ramifications for future results. Bear in mind that past performance is no guarantee of future returns. Past performance may provide clues as to future results. But, on their own, they are no guarantee of continued success. Risk and Returns In assessing fund returns, compare performance against the level of risk within the fund.

7 You can compare the fund performance against zero return, the rate of inflation, or the so-called risk-free rate of return (that is, the return on an investment that has no risk). You can also compare the investment risk for the category of your fund to other asset classes or investment styles. For example, I would expect that over the mid to long-term, riskier equity funds should outperform money market funds or other low risk investments such as term deposits, treasury bills, and the like. Remember that as risk increases, so should the expected returns. A fund of US government bonds should have less risk than a fund composed of bonds from developing countries or a fund with bonds from distressed companies. Because of the greater risk, I would expect the funds from the developing countries or distressed companies to have higher long-term returns than a US government bond fund. What the risk premium should be is up to the individual investor. ABC earned 11% annually over 5 years. Perhaps very low risk money market funds generated 3% annually over the same 5 years. For some investors the trade-off between equity risk and expected returns is warranted. Other investors will prefer the safety of the money market funds, rather than the potential extra return from the equity. Comparing fund performance against assets of higher or lower risk gives some comfort as to the expected risk-return tradeoff. This has some use for analytical purposes, but it does not assist in choosing a specific fund to invest in. For that, you need to look at a fund s direct competition. Peer Group Review

8 In comparing funds for possible investment, historic returns alone do not mean that much. What does it really tell me to know in isolation that ABC had a 1 year return of 12% and a 5 year annual return of 11%? Not a lot. I need to put the numbers in context. A fund s peer group is made up of the funds with the same investment style. From our example, all Canadian equity small-cap funds would be a peer group for ABC. Now we can start putting some context to ABC s performance. If the average Canadian equity small-cap mutual fund had a 5 year annual return of 8%, the 11% from ABC appears strong. Do not stop there though. You should also look at the ranking of ABC within its peer group. Perhaps 10% of the peer group had 5 year annual returns exceeding 20%. Another 20% had returns greater than 15%, and another 20% had returns higher than 12%. ABC had better 5 year annual returns than the average for the entire peer group. But when looking within the peer group, at least half of the funds outperformed ABC over the 5 year period. Seeing that, I might want to consider the funds that exceeded 20% return over ABC. When determining which funds to invest in, comparison to a fund s peers is very important. And like with historic returns, the longer the comparative periods, the better the analysis.

9 Benchmark Returns Another excellent way to assess performance is to compare it against a benchmark return. Benchmarks can be anything. However, in practice, broad indices are used that try to most closely reflect the investment style of the fund. An appropriate benchmark for ABC might be the BMO Nesbitt Burns Small Cap Index. The BMO index tracks smaller capitalized Canadian companies. This is preferable to the better known S&P/TSX Composite Index. Why? Because the TSX Composite Index is weighted by market capitalization, so it has a large-cap bias. To the extent possible, always try to compare apples to apples. For many funds, you do not need to create your own benchmark. The fund itself determines a benchmark for comparison and discloses the benchmark to investors. Always check to ensure that a fund s benchmark is truly representative of the fund s investment style. In our example, comparing the performance of ABC to 90 day U.S. Treasury Bills or 30 year Euro bonds makes little sense. There may also be a standard benchmark for the peer group within which your fund sits. That way it is easy to compare funds within a specific peer group to each other and the same benchmark. A major problem with comparing fund performance to an index is that the fund has operating expenses. An index does not. The greater a fund s total expense ratio, the larger the performance deficit versus the benchmark. As a result, funds start at an immediate disadvantage when trying to beat their benchmarks.

10 Consider an index fund that mirrors the S&P 500. To the extent that it can duplicate the index, the gross performance of the fund should match the performance of the S&P 500. Perhaps the gross returns for both were 10% last year. But the fund also has a 2.0% total expense ratio. So, on a net return basis, the index fund under-performed the benchmark by 20% (10% for the S&P 500 versus 8% net return for the index fund). Another thing to watch with benchmarks is that the fund sticks with its chosen benchmark. Should the fund change its investment style, it may be appropriate to modify its benchmark. But if it changes its benchmark simply to hide under-performance or in trying to make itself look better, be wary. Summary Past performance is not an indication of future investment success. It may show a consistency of performance, especially if you look at longer term results. And it may indicate potential problems or changes within a fund. While historic returns have some value, you should compare a fund s returns against other asset classes of differing risk. Even more important, always compare a fund s performance against its peers and objective benchmarks. In assessing peers, look at both absolute returns and the fund s ranking within the peer group. In reviewing returns against a benchmark, ensure that the chosen benchmark is appropriate for the investment style of the fund.

11 Assessing Investment Returns In our first look at investment returns, we reviewed a few common return calculations. If you know the formulas, the calculations are quite simple. The key is to know what is included and excluded from the different returns. But even with the hard calculations, returns can mean different things to different investors. Today we will consider some of the qualitative aspects in evaluating investment returns. Return, like risk, is in the eye of the beholder. Never be seduced simply by the quantitative side of investment returns. Always look at results from a other angles as well. I think this is just as important as the hard numbers. Unfortunately, it is an area many investors ignore to varying degrees. Do so at your own peril. Expected Rate of Return Before we get into today s session, I quickly want to review a topic we have previously discussed. Expected return is the anticipated asset performance for the future period under consideration. There are a variety of ways to calculate expected returns and most incorporate multiple variables.

12 Historic returns, probability and scenario analysis, company specific expectations, general market and industry specific expectations, risks, risk-free returns, etc. There are many factors that go into determining an asset s expected return. Because these returns are expected, there is a probability that the actual results will differ. This is where our earlier discussions of standard deviations come into play. The larger the standard deviation (i.e. the greater the volatility of the asset), the less likely that the actual return will equal the expected return. As the level of risk lessens, the certainty of the result rises. It is only in investments that have no risk that the expected return will always match the nominal return. In our analysis below, we shall use this simple example. You invest $1000 in an asset on January 1. You sell the asset December 31 for $1250. There were no cash flows so your total return (also, in this example, your holding period and annual returns) is $250 or 25%. Nominal Rate of Return While expected returns are forward looking, nominal returns reflect what actually occurred. This is the most common way to express a return. The nominal return is the investment return unadjusted for any other factors. In our example, the nominal return is 25%. A good number to know. But on its own, there is no context. And we always need context. Well, at least those who want to properly invest do. How do we put nominal returns in context? You need to use

13 comparative data. Real Rate of Return The real rate of return adjusts the nominal return to eliminate any impact from inflation. We discussed the affect of inflation previously. Let s say that your investment above was made in the United States where the annual inflation rate is running at 3%. Your real rate of return therefore is only 22% (25% nominal minus 3% inflation). Not too significant an impact. However, perhaps you live in Venezuela where inflation is about 30% annually. Your real return becomes a loss of -5%. Even though you made a 25% profit (on which you will be taxed), you have actually lost 5% in purchasing power over the year. When investing, always consider the impact of inflation on your returns. Its impact on your real returns can be substantial. Risk-free Rate of Return The risk-free rate of return is the return on an investment that carries no risk. That is, the outcome or return is known with 100% certainty. If the expected return is 10% or $100, you are fully guaranteed the result. While it is debatable as to whether any investment can be termed risk-free, for investment purposes certain government short term debt issues are considered to be certain. In the United States, the 13 week US Treasury Bill (T-bill) is considered to be a risk-free investment at this time.

14 Why is knowing the risk-free rate of return important? It is believed that investors are rational creatures. That means that all else equal, investors will choose the more efficient investment option when faced with two choices. Efficiency, in this case, refers to the relationship between risk and return. When having a choice between two investments of identical risk, investors will always select the asset with the higher expected return. Alternatively, when choosing between two investments with identical expected returns, investors will choose the asset with the lesser risk. While not always followed in practice, it should make sense. For example, say 13 week US T-bills offer a effective, annual return of 10%. In essence, the risk-free rate is also 10%. That means you could invest in T-bills and be guaranteed a nominal annual return of exactly 10%. Since all other investments have a higher level of risk, rational investors will never accept less than a 10% expected return for a risky investment. The greater the risk, the higher the return demanded by the investor. US government bonds are less risky than most corporate bonds. Therefore, if you look up yields on different bonds, you will see higher yields on corporate versus US government bonds with the same characteristics. Similarly, riskier companies must pay higher interest rates than more secure companies. This is the same as personal loans from your bank. If you are a valued client with lots of assets, you might get a loan at the prime interest rate. But if you have no track record of repayment or have had difficulties making debt payments in the past, you will need to pay higher rates than prime.

15 Use the risk-free rate of return as a minimum benchmark when considering investment options. If the risk-free rate is 10% and you are contemplating an investment with an expected return of 15% and standard deviation of 10%, you might give pause. Yes, the potential return is higher than US T-bills, but the risk is significantly higher. In fact, 95% of the time, your actual return will be anywhere between 35% (good) and -5% (not so good). Whether you think this is a better investment than the T-bills is based on your own risk tolerance. But by knowing the risk-free rate, you have additional information to make better decisions. Relative Rate of Return With the real and risk-free rates of return we considered investment options relative to inflation rates and guaranteed returns respectively. But you should also compare your investment returns to other benchmarks. These include: prior year results; analyst or company expectations; the market as a whole; the industry in which the asset lies; predetermined benchmarks. In our example, the nominal return was 25%. Sound s good. Actually, I have no idea if it is good or bad. I need more information. Perhaps the investment in our example was Fantasy Bank shares. I would be interested in how the shares performed over the previous years. If the 5 year average return was 40%, maybe 25% this year is relatively weak. What if I told you the general stock market grew 12% over the

16 year and that the average banking industry shares rose 30%. You would be happy that your stock outperformed the general market return, but unhappy that you underperformed other banking stocks. When examining potential investments, you consider the expected returns. For many investments, analysts and industry experts have expectations for the coming year s returns. If analysts had predicted that Fantasy would grow by 50%, you might be disappointed with 25%. Especially if you based your investment on a risk-return profile incorporating the 50% expected return. You can set up a variety of other benchmarks to compare performance. But you should always compare your actual and expected returns relative to predetermined criteria. That gives you a few thoughts as to why you should never consider investment returns in isolation. Always compare your actual and expected returns agains relevant benchmarks. Your decision-making and portfolio performance will benefit. Next in our investment series, some further evidence that all returns are not the same.

If you are over age 50, you get another $5,500 in catch-up contributions. Are you taking advantage of that additional amount?

If you are over age 50, you get another $5,500 in catch-up contributions. Are you taking advantage of that additional amount? Let s start this off with the obvious. I am not a certified financial planner. I am not a certified investment counselor. Anything I know about investing, I ve learned by making mistakes, not by taking