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Portfolio > Portfolio Construction

Using Benchmarks to Spark Constructive Conversations With Clients

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Few advisors would argue that performance reporting can be a distraction. Who among us hasn’t endured that uncomfortable client meeting where the conversation focused on the one manager that underperformed? Fortunately enough, the sophistication of performance reporting software today allows an advisor to at least drill down to an explanation. But from a practice management standpoint, we suggest far more beneficial conversations can be driven by a performance report tailored to help the client focus on the bigger picture. Granularity is fairly easy; the trick is to broaden the discussion.

Let’s Talk About the Sum of the Parts

In the past, performance reports were configured to focus on the pieces of a portfolio. Indeed, for years the industry focused mostly on the security level as the source of added value. Today, it’s generally accepted that the main sources of alpha are asset allocation and portfolio construction decisions. The art and science of portfolio management, meanwhile, has evolved from one-size-fits-all investment products to constructing dedicated portfolio solutions designed to reach the return objectives defined by the investor.

Against this new backdrop, more thoughtful firms are focusing their performance reports on the sum of a portfolio’s parts: the total portfolio, in other words. Some are even aggregating accounts at the household level. The overhanging question in this model, of course, is how do you meaningfully benchmark a total portfolio?

Let’s Talk About What Money Will Buy

We know that measuring total portfolio performance against a general market index like the S&P 500 is not the answer. This kind of basic benchmarking does little, if anything, to indicate how well an individual investor’s total portfolio is performing versus expectations. Only slightly better is a “custom policy benchmark,” which is created by blending the benchmarks of the underlying positions and assigning the same weight as in the portfolio. This approach offers a more relevant comparison for the total portfolio, but in highlighting the relative benefit of manager selection, it opens the door for the client to focus on any one of the portfolio’s underlying parts.

The best way we know to place emphasis on the overall portfolio and shift an investor’s view toward a long-term goal is employing a real return target for comparison. Real return is defined as the performance above inflation, its object being to ensure that a portfolio does not diminish in value over time. Pension funds take this approach by using actuarial rates.

For the individual investor, one possibility for a real return target is the measure of inflation plus a margin, known as CPI+. From a goals-based standpoint, an advisor is well served by emphasizing the long-term impact of inflation, even in low-rate environments like the one we’re in now. Why? Because the average investor, already a bit scared, scarred, and skeptical, may think investing in Treasuries with a 2% coupon will provide a relatively decent return. Using a CPI+ benchmark gives you a natural opening to discuss how inflation would chip away at the value of that return and the underlying portfolio over time. A rate of inflation greater than the Treasury yield for example, would have a cumulative negative impact on a retiree drawing a fixed income.

Let’s Talk Clearly

While CPI+ is fairly straightforward, inclusion of other return-based measures in a performance report should be predicated on the investor’s level of sophistication. It’s easy to forget that a volatility measure like standard deviation, while well known in the investment community, is not so commonly understood by most investors. Too often it appears as just another confusing number lacking context. Measures that are better understood, on the other hand, go much further toward facilitating the performance discussion. Talking about historical declines in down markets instead of standard deviation, for example, puts risk in a framework any investor can understand. Collectively, performance measures that are more easily explained help an advisor gain a better understanding of his or her client’s comfort level.

There’s no denying that performance reporting can prove to be difficult for advisors and their clients. But there are ways to analyze the asset allocation and portfolio construction decisions that will improve investors’ welfare. Constructing a performance report that directs the focus to the overall portfolio in terms an individual investor can understand can be a boon for maintaining the focus on their long-term goals.


Author’s disclaimer: For investment professional use only. Past performance is not indicative of future results. The opinions expressed herein reflect our judgment as of the date of writing and are subject to change at any time without notice. They are not intended to constitute legal, tax, securities or investment advice or a recommended course of action in any given situation. Investment decisions should always be made based on the investor’s specific financial needs and objectives, goals, time horizon, and risk tolerance. Information obtained from third party resources are believed to be reliable but not guaranteed. Any mention of a specific security is for illustrative purposes only and is not intended as a recommendation or advice regarding the specific security mentioned. Diversification does not guarantee a profit or guarantee protection against losses.


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