When talking about investment planning, it is easy to get confused between the terms ‘returns’ and ‘performance’. The two measures are important in assessing investment strategy but should not be confused. Returns are the percentage growth, or loss, an investment has experienced over a given time period. Performance accounts for other factors such as risk, diversification and portfolio behaviour.
The Oxford Dictionary defines a benchmark as ‘A standard or point of reference against which things may be compared.’ When looking at investments, benchmarks are much more than points of reference. They are used by investors to gauge how a portfolio is performing and by managers to check their strategy is in line with expectations.
Choosing an appropriate benchmark is one of the most important decisions an investor makes but it is often overlooked. We hope to shed some light on the importance of benchmarks and how FC Financial Planning uses benchmarks for our clients.
Why is picking the right benchmark important?
Picking the right benchmark makes sure you are comparing apples with apples. The wrong benchmark sends the wrong message and uses the wrong performance measures. For example, if a global medium risk portfolio were to be benchmarked against the S&P 500 (US stock market index consisting of America’s 500 largest companies) we would be comparing a portfolio invested across the globe to the performance of a single country. There is a big difference in risk and geographical spread, so the portfolio will behave very differently to its benchmark.
It is important to recognise the difference between a benchmark and a simple reference point. Not many investors are familiar with the ‘Investment Association Mixed Investment 40-85% Index’, so whilst it may be an appropriate benchmark for performance comparison, it doesn’t mean much to the investor. Sometimes a home bias index is used to give investors an idea of how their portfolio has performed relative to a major index. The FTSE All share index is not appropriate for most global portfolios as a benchmark, but having it present for familiarity can help UK investors visualise how their investments have performed relative to a recognisable reference point.
The chart above shows the performance of the FCFP Balanced portfolio over the 2020 calendar year compared against 3 commonly used benchmarks. The FTSE All share index is used for familiarity. While it is encouraging to see the FCFP portfolio achieving greater returns over the 12 month period compared to the FTSE index, the risk level of the two are different so another benchmark is needed.
The IA Mixed Investment 40-85% Sector is suitable for looking at the performance of a balanced portfolio. It is a useful comparison to an industry average for a medium risk level. Our Investment Committee will look at the return on all our core investment solutions relative to the most appropriate IA Sector to see how they are behaving compared to industry peers.
While it is nice to see the FCFP portfolio providing a greater return than the most appropriate IA Sector, it is important not to get caught up in the return figures of peers. This is why we use the RPI + Target. RPI is the retail prices index; a widely used measure of inflation. We believe a balanced portfolio should provide returns in the region of RPI + 2.5%, essentially 2.5% above inflation. This allows our financial planners to help set expectations with their clients.
How does FC Financial Planning view benchmarks?
A benchmark is best used as an anchor point to check whether a portfolio is behaving as expected. At FC Financial Planning we believe in goal-based investing. Our investment strategies are targeted to achieve our clients’ goals, not to outperform a particular market index. An investor’s goal could be to have enough capital to retire in 5 years’ time, or for their investment to keep up with inflation plus extra spending money. Setting a goal at the start of investing is crucial as it will allow for regular check-ups on whether the portfolio is on track.
We like our clients to be able to view their investment strategy relative to something familiar, but also find it important to demonstrate their portfolio is in line with the strategy agreed at outset. To achieve both points, our reviews typically contain two points of reference; the FTSE All Share index and an agreed RPI + target appropriate for the client’s approach to investment risk and goals.
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