Put peer comparisons in context and evaluate what is being measured.
Performance benchmarking, peer comparisons, and regret avoidance
Let’s say you were visiting your wealth advisor for your annual portfolio review, and the advisor pulled out a performance chart comparing how your portfolio had done relative to your local neighbors. “Look how well your portfolio did last year, you were in the top third of investors living on Addison Street in the most recent quarter and over a three-year period!” How might you react to this report? It might seem an odd measure, given that one neighbor has six children and large college bills looming, another is a young neurosurgeon whose husband is a corporate attorney and their combined income is double yours, and the Nelson’s are in their 80’s, retired, living on a fixed income. Comparing your own performance to theirs feels flawed. And it would be – your investment portfolio and its performance should be evaluated based on your unique goals and objectives, accounting for your financial constraints and risk tolerance. You might rightly think maybe I should find another advisor.
Yet, institutional investors regularly apply this same conceptual approach when evaluating their own portfolios. Peer comparisons are a regular and often demanded method of evaluating performance, occupying a consistent spot in otherwise busy investment committee schedules. It is one of a wide range of portfolio benchmarks, complicating evaluation while offering limited and somewhat debatable value to the challenging task of portfolio construction evaluation. What value are comparisons to other institutions, with differing capital demands on their portfolios, varying levels of operating stability, and different risk tolerances, of value to your investment committee? To put peer comparisons in context, we first must evaluate what is being measured.
We believe the biggest risk faced by an institutional investor is not portfolio volatility itself, but rather the capital claims on that portfolio in periods of market stress. Investment portfolios carry varying degrees of risk, but the impact of that volatility would be somewhat limited if no capital was being drawn. The timings, size, range, and flexibility associated with those capital draws is the real transmission mechanism for adverse markets to most deeply impact portfolio values. As those circumstances vary considerably for institutions, asset allocation begins with a detailed understanding and scenario analysis of the drivers and scope of those capital demands. This provides guidance into the role of the portfolio, and ultimately determining the appropriate level of market exposure (Beta*) and portfolio liquidity (percentage of the portfolio in less liquid or private markets). These strategic asset allocation decisions ultimately drive as much as 90% of the institutions portfolio outcomes. (Source: Brinson, Singer, and Beebower (1991).
Understanding that the driver of the bulk of performance is an outcome of the strategic asset allocation is an important consideration when benchmarking. If approximately 90% of performance is a function of the strategic allocation, and that allocation is based on the unique characteristics of that institution, peer benchmarking is in effect measuring the remaining 10% of investment decisions. Unless the peer benchmark is composed of other institutions with identical financial constraints and risk appetite, it will likely be both inappropriate and provide insight into only a fraction of the discretionary investment decisions.
Other important perspectives include:
Given peer comparisons are generally contrary to the fundamentals of institution-specific asset allocation, offer limited insight into any single institutions strategy, and are in many ways evaluating a fraction of the discretionary portfolio decisions, why are they so often applied? In some respects their use reflects the challenges of evaluating an investment portfolio and its implicit decisions in a reasonable timeframe. They also reflect the very real typical investor behavioral challenge of fear of missing out. Just as stories of a friend’s favorable experiences in investing leads to both feelings of jealousy and regret, so too can peer comparisons generate similar experiences within an investment committee. Besides generating discomfort with a long term appropriate strategy based on short term variation, this pressure can often fuel a strategy shift away from an institution appropriate strategy, into some asset or asset class that worked last year but might not work next year, or into a private asset class that seems attractive but whose liquidity constraints might pose longer term challenges. Regret avoidance, while a common individual investor trait, is not an appropriate institutional characteristic, and investment committees should seek to avoid allowing that behavioral bias from affecting long term portfolio strategy.
Rather than focus on comparing short term outcomes between two different yet institutionally appropriate strategies, investment committees should focus on evaluating:
Variance against different benchmarks can add useful context to portfolio decisions, but are not ideal scorecards for evaluating the appropriateness of a portfolio for the unique circumstances of the institution. Rather than spend time each quarter, the investment committee would be better served conducting more detailed benchmark reviews annually. Variance analysis should be focused on the information provided versus a scoreboard of success or failure. In addition to providing more useful long term information and perspective, investment committee time should be freed up for strategic roles such as setting and reviewing institutional progress, strategic goals, and objectives oversight.
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* Beta is a measure of the volatility—or systematic risk—of a security or portfolio compared to the market as a whole.
* Alpha refers to excess returns earned on an investment above the benchmark return when adjusted for risk.
Diversification may not protect against market risk. There is no assurance the goals of the strategies discussed will be met.
This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events or a guarantee of future results. All information as of the date indicated.
The information contained herein is for general and educational information purposes only and is not intended to constitute legal, tax, accounting, securities, research or investment advice regarding the strategies or any security in particular, nor an opinion regarding the appropriateness of any investment. This information should not be construed as a recommendation to purchase or sell a security, derivative or futures contract. You should not act or rely on the information contained herein without obtaining specific legal, tax, accounting and investment advice from an investment professional.
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