The U.S. stock market rally over the last five-and-a-half years has led to impressive returns across nonprofit investment portfolios. While it is easy to become complacent in a period of outsized returns, fiduciaries must ask themselves two critical questions:
Importance of Benchmarking
Fiduciaries are concerned with growing the assets of their foundation or endowment. Over the last five-and-a-half years, many organizations have seen that goal realized, as the U.S. stock market, international stock markets, global bond markets and real estate have all offered impressive returns. In fact, many organizations have been able to fulfill their spending requirements and still realize substantial appreciation of their portfolio. While it is easy to get comfortable when portfolios continue to grow, fiduciaries should work to ensure that their organization is maximizing opportunities. But how can a nonprofit determine if they are truly maximizing the opportunities in the markets? The answer comes from portfolio performance attribution through relevant benchmarking.
Establishing a benchmark is critical for many reasons, the most important of which is understanding the source of performance. For example, an investment portfolio may earn a return of 10% in a given year. A 10% return allows the organization to meet all budgeted spending requirements, keep pace with inflation, and experience real growth. However, over the same period a collection of stock and bond indexes that match the targeted allocations within the portfolio returned 15%. Fiduciaries might reward investment managers for the perceived success coming from the 10% return, when in reality the manager is failing to add any value through security or fund selection. Without understanding the endowment or foundation’s performance relative to a carefully selected benchmark, the long-term performance of the organization could be compromised.
Selecting the Right Benchmark
Before an organization determines an appropriate benchmark, it must first consider the asset allocation decisions. The initial asset allocation discussion determines the markets and asset classes that are appropriate to include in the investment portfolio. The discussion should concentrate on proper risk mitigation through diversification, but also focus on ensuring that each asset class serves a particular purpose within the portfolio. Once the initial asset allocation discussion is complete, the next step is to determine how to invest in each asset class. Selecting an asset class benchmark is the first part of that process.
When choosing the proper benchmark, there are several factors to consider:
- A benchmark should be investable. The benchmark should contain publicly-traded securities and should be replicable. A benchmark that can be replicated will typically lead to several low-cost passive fund options that seek to track performance of the benchmark. Having such availability provides an option for index-like exposure to the asset class, which is generally a different type of exposure from an actively managed strategy.
- Historical data should be available. Having historical data available allows investors to understand the risk and return profile of the allocation over multiple time periods and various market cycles.
- Industry use. It is important to consider how widely a specific benchmark is used by investment managers. Benchmarks that are more widely used by investment managers normally result in more available investment options using active strategies.
- Benchmark holdings should reflect targeted exposure. A benchmark should represent the types of exposures an investor is looking for within an asset class. For example, an investor who is looking to invest in investment-grade fixed income, but does not want any exposure to mortgage-backed or asset-backed securities, should select a benchmark that does not have these exposures. Likewise an organization that does not wish to be exposed to fluctuations in foreign currency exchange rates would select an international equity benchmark that hedges any foreign currency risk.
- The benchmark should be purposeful. If an asset class included in the portfolio has a specific purpose, then the chosen benchmark should accomplish that purpose. For example, some organizations choose to allocate to international equities in emerging markets as a way of enhancing total portfolio returns. A benchmark that only tracks the performance of large, stable, international companies would not be a fit, as it likely would not accomplish the intended purpose of the allocation.
Once individual asset class benchmarks are selected, an organization can use these as the basis for performing an asset allocation study. In an asset allocation study, risk, return, and correlation assumptions are developed for each asset class, using the selected benchmark as a starting point. Once the assumptions are in place, a variety of different asset class weightings can be tested to determine ideal target allocations for the portfolio. These targets and appropriate ranges will then serve as the asset allocation guidelines.
In addition to individual asset class benchmarks, nonprofits should implement a total portfolio benchmark. This custom benchmark can be a weighted-average of the asset class benchmarks, with the weightings based on the target allocations. Incorporating a portfolio benchmark comprised of the individual asset class benchmarks allows for an additional layer of performance attribution when analyzing performance results.
Understanding Performance through Benchmarking
The key outcome from successful benchmarking is a deeper understanding of the sources of performance within the portfolio. Having a deeper understanding of the sources of underperformance or outperformance allows committee members and other fiduciaries to make more informed decisions regarding asset allocation and manager selection.
Analyzing portfolio performance relative to a total portfolio benchmark allows committee members and fiduciaries to see the impact of asset allocation decisions. If a portfolio has underperformed the benchmark, this level of attribution can help to determine how the weightings in the portfolio relative to targets led to this underperformance. For example, assume an organization underperformed its benchmark for the year. During the year, the portfolio had an allocation to U.S. equities of 23%, while the target allocation (as reflected in the portfolio benchmark) called for a 30% allocation. If U.S. equities returned 15% for the year, while the rest of the portfolio returned 7%, it can be calculated that the portfolio gave up 0.6% in total portfolio performance by being under-allocated to U.S. equities.
Asset class benchmarking allows for an additional level of performance analysis and attribution. While asset allocation relative to targets can be responsible for underperformance or outperformance, returns within an asset class should also be examined. In another example, let us assume an organization underperformed its benchmark for the year. However, the portfolio allocations matched those of the benchmark. In this scenario, the underperformance cannot be tied to asset allocation decisions. It then makes sense to compare actual performance within an asset class to the benchmark for that asset class. This level of performance attribution shows how successful investment managers were at selecting individual securities within an asset class. This analysis assists committee members and other fiduciaries in understanding how successful chosen investment managers are within a certain asset class, and aids in decision-making regarding the selection of investment managers.
Successful benchmarking and performance attribution allows fiduciaries to have a better understanding of the performance of their foundation or endowment. Armed with this knowledge, fiduciaries are able to determine if they are truly maximizing opportunities in the market and more accurately articulate performance of the investment portfolio to current stakeholders and prospective donors.
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