by Edward P. Rennie and Thomas J. Cowhey
The
Successful Use
of
Portfolios: A Case
Benchmark
Study
Benchmark
portfoliosarecustom-tailored
performance
benchmarks
thatreflectthestyle of an
investmentmanager.Theyallowfor moremeaningfulevaluationof portfolioperformance
becausethey separatethe results of investmentstyle from those of investmentdecisionmaking.In addition,theycanbecombinedwith performance
attributionanalysisto examine
the effectsof markettimingand sector,industryand securityselectionon the portfolio.
Some of the issues that need to be addressedin implementinga benchmarkportfolio
approachinclude the treatmentof cash positionsand transactioncosts, the frequencyof
rebalancing,implementation
and monitoringcostsand the use of multiplebenchmarks
for a
firm. Thebenchmark
portfolioprocessis hamperedby a lackof standardsand by thevarying
investmenthorizonsneededto assessdifferentportfoliostrategies.Despitetheseshortfalls,
the processis beneficial.
B
ENCHMARKPORTFOLIOSare custom-
tailored portfolios that reflect the particular style of an investment manager.
Rather than using the S&P 500 as a performance
standard for all equity managers, for example, a
benchmark portfolio approach would use a
benchmark portfolio with value characteristics
for a value manager, a benchmark portfolio with
growth characteristics for a growth manager
and a benchmark with small-capitalization characteristics for a small-cap manager. Benchmark
portfolios allow for a more meaningful evaluation of investment performance, regardless of
the performance of the investment manager's
style relative to the market.
Figure A illustrates the cumulative excess
return of one of Bell Atlantic's growth managers
versus its own benchmark portfolio and the
benchmark versus the S&P 500 over the period
January 1984 through June 1988. The S&P 500
outperformed the growth benchmark. The investment manager, however, also outperformed the growth benchmark.
The investment manager was successful at
adding value relative to its benchmark portfolio,
even though the firm's investment style, as
represented by its benchmark portfolio, underperformed the S&P 500. This demonstrates how
misleading performance evaluation relative to
the S&P 500 or other broad-based index can be.
As practitioners who have worked over the
past five years to maximize the benefits of
benchmark portfolio use, we would like to disFigure A
Cumulative Excess Return
20
18 16
1412 10_I
Manager
8
6
2 tvs. Benchmark
4
r~
2
-2
-4
-6
Benchmark
vs. S&P 500
-8
1/84
1/86
1/88
FINANCIAL ANALYSTS JOURNAL / SEPTEMBER-OCTOBER 1990 C 18
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is collaborating with JSTOR to digitize, preserve, and extend access to
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®
www.jstor.org
Glossary
BenchmarkPortfolio: A performanceindex that is
constructedfrom a list of securitiesand weights
that have been selected to reflectthe investment
style of the portfolio under evaluation.
Active Management Return (AMR): The difference between the return of the actual portfolio
and that of its benchmarkportfolio;also referred
to as the excess return.The benchmarkportfolio
return is a monthly buy-and-hold return. The
cumulative excess return, or cumulative AMR,
is the difference between the actual portfolio
return and the benchmarkreturn over the evaluation period.
Portfolio Attribution: The decomposition of a
portfolio'sexcess returninto four componentsmarket timing, industry selection, sector
(BARRArisk factor)selection and securityselection.
Unreconciled Return:The portion of the AMRthat
cannot be attributedto one of the four attribution components.
cuss some of the subtleties of the benchmark
process. The techniques for constructingbenchmark portfolios are fairly well known, and it is
not our intention to dwell on them here. We
will, however, review briefly Bell Atlantic's
benchmark portfolio process.
Benchmark Portfolio Construction
Bell Atlantic has used benchmarkportfolios for
evaluating the performance and skills of its
existing and potential domestic equity investment managers since the company's inception
in 1984. More recently, we have begun developing country benchmark portfolios for our nonU.S. equity managers.
Bell Atlantic retains a consultant to perform
the computer analyses and to provide advice on
Figure B
the process. The process itself utilizes the
BARRAPerformanceAttribution and Analysis
Models.
The benchmark portfolio process consists of
construction and maintenance of a benchmark
portfolio for each existing and/or potential equity investment manager and a performance
evaluation and attributionanalysis of each manager's portfolio returns versus the benchmark
portfolio returns.
The construction or development of each
benchmark portfolio represents a cooperative
effort between Bell Atlantic and the investment
manager. The process consists of (1) defining
the universe of stocks to be used for the benchmarkportfolioand (2) defining the weighting of
the stocks in the universe.
Defining the Universe
Definition of a benchmark universe is based
upon discussions with each investment manager. Figure B gives a simplified schematic of
the process.
We startwith the entire universe of investable
securities. This universe, denoted "W," constitutes the approximately 5000 securities traded
on public exchanges and in the over-the-counter
market. Through discussions with the investment manager, this universe is narrowed down
to a smaller group of securities, "X," which
better represents the universe the manager considers eligible for investment, given its investment style. A growth manager, for example,
may only invest in securities with a five-year
earnings growth and average ROE in excess of
the market's. The universe W would be
screened using these criteria to arrive at the
manager's investable universe X.
While X is the universe of securities that
would be used in the investment manager's
benchmark portfolio, universe "Y" represents
Benchmark Universe Selection Process
5,000 Stocks on
Exchange& OTC
Manager's
Universe
Manager's
Buy List
"Managed"
Portfolio
FINANCIALANALYSTSJOURNAL/ SEPTEMBER-OCTOBER
1990 0
19
the investment manager's "buy list." This is the
list of securities from X that the investment
manager has researched or analyzed and identified as current candidates for inclusion in the
portfolio. This list is based on informationfrom
the investment manager's investment process
and should therefore not be used as the investment manager's benchmarkportfolio.
The final list, "Z," is the investment manager's actual portfolio.
It is easiest to define the benchmarkuniverse
for an investment manager that has preselected
a small universe of securities, researches them
on a continual basis and only invests in securities from that universe. One of our growth
managers, for example, has a universe of about
300 securities. That this universe is the benchmark portfolio is further confirmed by the fact
that the same names keep appearing in the
actual portfolio over many years and that the
manager's files contain research on only those
companies.
Defining the Stock Weights
Weights need to be assigned to the individual
stocks in the benchmark universe. This is a
criticalpart of the process because it can dramatically alter the benchmark portfolio characteristics and performance. In addition, it will influence the attributionanalysis.
Figure C illustrates the impact of different
weighting schemes on the characteristicsof the
Figure C
S&P 500 Sector Analysis
Variability?
41
in Markets
Equally
Weighted
Success
Size
Trading
Growth
Earnings/Price
Earning
s/Price _
Book/Price
EarningsVar.
Fin. Leverage
ForeignSales
LaborInt.
Yield
Low Cap.
_ i
~~~~Capitalization-Weighted
-0.8 -0.6 -0.4-0.2
0 0.2 0.4 0.6 0.8
Risk Exposure(standarddeviation)
Figure D
S&P 500 Performance
CapitalizationWeighted
-
EquallyWeighted
1984
1985
1986
1987
1988
S&P 500. The diagram shows the risk-factor
exposures for the equally weighted and capitalization-weighted S&P 500. The risk factors are
variability in markets, success, size, trading,
growth, earnings/price ratio, book/price ratio,
financial leverage, labor intensity, foreign income, yield and low capitalization. (We also
consider industry factors, but these have been
excluded from this chart for simplicity.) In our
analyses, we referto the risk-factorexposures as
sector exposures.
Not surprisingly, the largest difference between the two weighting schemes is in size. The
equally weighted S&P 500 has a lower capitalization than the capitalization-weighted S&P
500. Note also, however, the lower yield, higher
growth and higher earnings variability of the
equally weighted S&P 500.
Figure D shows the annual performance results for the equally weighted and capitalization-weighted S&P 500. There are substantial
differences. This illustrates why the weighting
process is such an important part of the benchmark construction process.
Bell Atlantictypicallyexamines an investment
manager's month-end portfolios over the past
five years as a guide in determining the weights
to be used in the investment manager's benchmark. The historical portfolios are used to determine the average exposure of the manager's
actual portfolio to the risk and industry factors
and the variability of these exposures. The
weightings of the securities in the benchmark
portfolio are then adjusted to reflect the investment manager's average exposures.
Figure E shows the actual average factor exposures of one of our investment managers over
FINANCIAL ANALYSTS JOURNAL / SEPTEMBER-OCTOBER1990 n 20
Figure E
Investment
Manager Risk-Factor
capitalization, lower P/E (higher E/P) and lower
growth than the average capitalizationweighted stock in the universe. The exposures
and investment style are fairly stable. The more
stable the exposures, the easier it is to benchSize
I
mark the investment manager.
We monitor these exposures for all our manGrowth
agers. An increase in the variability of the expoE/P
sures could signal problems with the firm or the
investment process. For example, the firm may
B/P
be taking larger factor bets to improve poor
performance. This would be contrary to the
Earnings Var.
investment manager's process and would warFin. Lev.
rant a closer review.
An increase in the level of the exposures
For. Sales might also be symptomatic of problems with the
process or the organization. In this example, the
LaborInt. growth exposure of the portfolio has been increasing. This might be a cause for concern,
Yield
considering that the manager is a value manager. The P/E exposure, however, has remained
- 1.0
- 0.6
-0.2
0.2
0.6
1.0
fairly constant. This suggests that the investRisk Exposure (standard deviation)
ment manager is adhering to the value investI Actual
EquallyWeighted
ment process, but that growth stocks are becomw
Portfolio
Benchmark
ing eligible for inclusion in the portfolio.
B
Capitalization
m Actual
m
Weighted Benchmark
1 Benchmark
We make some minor variations in the benchmark construction process for different investment styles. For example, a broadly diversified,
the period December 1984 through November core-type, active equity investment manager
1988. It also shows the exposures of the manag- may have as its investable universe the entire
er's equally weighted benchmark portfolio, its equity universe, or some subset of the universe
capitalization-weighted portfolio and the actual represented by an index (i.e., there would be no
benchmark portfolio used in our analysis as of universe X or Y in Figure B). In these situations,
November 30, 1988. The actual portfolio expo- the appropriate index is used as the investment
sures are not very closely related to either the manager's benchmark portfolio. Also, in some
equally weighted or capitalization-weightedex- investment management firms, the portfolio
Analysis
posures. (Note especially size, growth and foreign sales.) The stocks in the benchmark universe were weighted to reflect more closely the
actual exposures in the portfolio.
Historical actual portfolio exposures not only
help define the benchmark portfolio, they also
provide insight into the investment management process. Figure F shows one investment
manager's historical exposures to three risk factors-size, E/P and growth. When the lines are
above (below) zero, it means that the investment manager has a higher (lower) capitalization, higher (lower) E/P and higher (lower)
historical growth rate than the average capitalization-weighted stock in the estimation universe.
Historically, this investment manager has
tended to invest in securities with a higher
Figure F
Historical
Risk Exposures
1.0
E/P
0.5
Size
00
-n
-0.5
Growth
0m
-1.0
.
,
1984
1985
1986
FINANCIAL ANALYSTS JOURNAL / SEPTEMBER-OCTOBER 1990 D 21
., I
l l l l l l l l l l l
1987
1988
Table I AMRs and Sources of Returnfor SeveralManagers
Actual Return:
BenchmarkPort. Return:
AMR (ConfidenceLevel):
Components of Return:
MarketTiming
Industry Exposure
Sector Emphasis
SecuritySelection
UnreconciledReturn
ManagerA
19.1%
14.9%
4.2% (99)
ManagerB
17.0%
15.2%
1.8%(53)
ManagerC
12.6%
12.6%
0.0%(3)
-0.2% (40)
0.2% (20)
2.2% (99)
1.9%(84)
0.1%
-0.6% (64)
-2.0% (89)
3.9%(99)
0.6%(43)
-0.1%
-0.5% (73)
0.3% (34)
0.3%(51)
0.1%(7)
-0.2%
manager is also the analyst. In this situation,
there is no universe Y.
What if an investment manager refuses to
participatein the process in any way? We have
never had this happen, but if it did, we would
move on to other investment managers. What if
an investment manager agrees to cooperate but
does not really put much credibility in the
process? We would have no problem with this.
Because we have confidence in and understand
the process, we feel we remain in an informed
position.
Performance Attribution
Performanceattribution analysis is a means of
evaluating an investment manager's performance returns and the sources of returns relative to a benchmark portfolio. The analysis
examines an investment manager's total excess
return, or active management return (AMR),
relative to its benchmark portfolio over the
given period. It also looks at four components of
AMR-market timing, sector selection, industry
selection and security selection. TableI provides
a summary of the results for a few investment
managers.
Investment Manager A has outperformed its
benchmark portfolio by 4.2 per cent per year
since the inception of the account. The confidence level of 99 per cent indicates that the
AMRis statisticallydifferentfrom zero. We infer
from this that the investment results were
achieved through skill, not just luck.
The significant sources of return for the AMR
were sector emphasis (2.2 per cent) and security
selection (1.9 per cent). The returnsfrom market
timing and industry exposure were not significantly different from zero. This means that the
manager either did not emphasize these skills,
or that its emphasis failed to affectthe portfolio.
A review of the manager'sinvestment process
provides further insight into these components
of return. This investment manager is attempting to add value through sector and security
selection. It does not profess to have any skill at
market timing or industry selection. The manager has therefore neutralized these components relative to its benchmark portfolio. The
results are thus consistent with the manager's
investment process. Based upon this analysis,
we believe ManagerA is a superior manager.
The unreconciled return in the analysis is the
differencebetween the manager's actual portfolio return and the return components from the
attributionmodel. The returns to the attribution
model are based on the buy-and-hold returns to
the portfolio of securities the manager held at
the beginning of each month in the analysis.
The attributionmodel returns thus do not incorporate the effects of intramonth trading or the
transaction costs associated with that trading.
The unreconciledreturnis typically low. A high
value might indicate a problemin the analysis or
an increase in portfolio turnover, or it may
reflect hybrid or non-equity securities in the
portfolio.
Manager B has outperformed its benchmark
portfolio by 1.8 per cent per year, at the 53 per
cent confidence level. From our perspective,
this is an acceptableAMR.The confidence level,
however, is not high enough to confirmthat it is
differentfrom zero and did not occurby chance.
As a result, we continue to monitor the performance of this manager for improvement or
deterioration.
The investment manageradded value from its
sector emphasis (3.9 per cent) but lost value
from its industry exposure (-2.0 per cent).
Market timing and security selection did not
have a significant impact. The manager's es-
FINANCIALANALYSTSJOURNAL/ SEPTEMBER-OCTOBER
1990El 22
Figure G
Sector Analysis
Risk Exposure(standarddeviation)
- 0.4 -0.2
0
0.2
0.4 0.6 0.8
Variability
in Markets_
ActiveExposure
Success Size
TradingGrowth
E/P
_
_
_
_
_
_
B/PEarningsVar.
Fin. Leverage_-
ActiveReturn
ForeignSales
Laborlnt. YieldLow Cap. -0.4
-0.2
0
0.2 0.4
Return(per cent)
0.6 0.8
poused objective is to identify and invest in
undervalued securities, with little diversification relative to its benchmark. The component
analysis indicates that the manager is having
difficulty adding value in these areas. This further supports the need for additional review
and surveillance.
Based upon this analysis, one might think it
would be worthwhile to tell Manager B to discontinue any consideration of industry bets.
Our experience suggests, however, that this
kind of meddling with investment style will not
be successful. It is like the old game of pick-up
sticks: You move one, and the whole structure
collapses.
ManagerC has equaled the performanceof its
benchmark portfolio, at the 3 per cent confidence level. None of the sources of return is
different from zero. The investment manager
has not added any value relative to the benchmarkportfolio. Furtheranalysis of this manager
is required, and consideration should be given
to possible terminationof the account.
Bell Atlantic expects its active equity managers to add a minimum of 1 per cent per year over
their respective benchmarkportfolios, at a high
level of confidence (70 per cent plus) over a two
to three-year investment horizon. In addition,
Bell Atlantic expects the results of the component analysis over the investment horizon to
substantiate that the investment manager is
adding value through the skills it emphasizes.
Benchmark Portfolios: The Good, The
Bad and The Ugly
In general, the benchmark portfolio process is
beneficial because it focuses on an investment
manager's investment process, rather than on
the investment style perse. An investment style
is bound to go in and out of favor over time.
Without segregating style decisions from investment processes, it is impossible to evaluate
effectively an investment manager's skills.
Benchmarkportfolios also provide meaningful informationabout an investment manager's
sources of return and risk, both in absolute
terms and relative to a benchmark portfolio.
Figure G, for example, illustrates a manager's
active risk-factorexposures relative to its benchmark portfolio and the returns associated with
those exposures. This sector analysis tells us
that the manager's large active exposure to
low-P/E, high-yielding stocks added value over
the quarter.
Suppose another manager was not trying to
take risk-factorbets. The manager might not
even be aware that its portfolio had factorbets.
They might simply be a residual of the investment process. This is important for the investment manager, as well as the plan sponsor, to
know, because unintentional factor bets can
have a significant impact on performance.
For a plan sponsor, the benchmark portfolio
process also provides a means of characterizing
different investment styles. These styles can
then be analyzed, considered and implemented
in a multimanagerframework.
There are, however, several practical problems associated with constructing and implementing a benchmark portfolio process. These
are discussed below.
Cash Positions
If an investment manager's portfolio typically
contains a small percentage of cash, should the
cash be included in the manager's benchmark
portfolio?It may appear appropriateto include
some percentage of cash in the benchmark.
However, allowing for cash in the benchmarkis
an implicit allowance for the manager to hold
cash. Over the long term, cash has a negative
impact on plan sponsor results.
Our philosophy has been that we want our
investment managers to be fully invested. If an
investment managerdecides to hold some cash,
we consider it an active decision for which the
investment manager should be held accounta-
FINANCIAL ANALYSTS JOURNAL / SEPTEMBER-OCTOBER1990 O 23
ble. This is especially true today, when there are associated with rebalancing.We typically rebalso many ways in which to equitize small ance the benchmarkportfolios for our managers
on an annual basis. This has proved to be
amounts of cash without sacrificingliquidity.
optimal, for us, in terms of maintaining the
desired characteristics.
Transaction Costs
In some situations, more frequentrebalancing
Should the benchmark portfolio be assessed
transaction costs? A benchmark portfolio is in- may be required. For example, a few large
tended to represent a passive investment alter- stocks in a benchmark portfolio may become
native to the investment manager's style. If takeover targets, and their prices may move
there are significanttransactioncosts associated enough that they no longer meet the manager's
with replicatingthe benchmarkportfolio, then a criteria.Not rebalancingthe portfolio more frebenchmarkthat excludes these costs is not a fair quently in these situations could affect the remeasure. For example, an equally weighted sults if the stocks represent a significantportion
benchmark must be rebalanced frequently in of the benchmarkportfolio's value.
order to maintain an equal-dollarinvestment in
each security. A passively managed, equally
Cash Flows
weighted benchmark would incur transaction
Periods involving significant cash flowscosts; they should therefore be included in the including initial funding, as well as any subseanalysis.
quent additions or withdrawals of cash or secuAt this time, we do not include transaction rities from the account-must be monitored
costs in our analyses. We are, however, cur- because they can affectperformanceresults and
rently reviewing the issue. There are two types analyses. Until the event is totally complete, the
of transactioncosts that need to be consideredportfoliois in a state of disequilibriumrelativeto
the initial transaction costs associated with es- a normallyinvested portfolio. Ratherthan try to
tablishing a portfolio and the ongoing costs analyze performance during such periods, we
associated with rebalancingthe portfolio.
typically disregard the transition period from
We typically exclude the first month's perfor- the analysis.
mance of a new investment manager from the
analysis because of transaction costs and the
Costs
initial imbalanceof the portfolio. In our process,
The benchmarkportfolio process is expensive
then, an investment manager typically is not in terms of both costs and the time and effort
penalized because of initial start-up costs. To required. Monthly portfolio data need to be
the extent the first month's performanceis in- gathered and maintained on an ongoing basis.
cluded in the analysis, transactioncosts should The data have to be reviewed for errors and
be assessed to the benchmarkportfolio.
correctedas required. Meetings need to be held
As for ongoing transaction costs, they are a with investment managers to review the profunction of the level of turnoverin a benchmark cess, the benchmark portfolio and the results.
portfolio and the liquidity of the issues. These Also, the analysis is detailed and requires time
points need to be addressed separatelyfor each and attention to understand and interpret corbenchmark.We typicallyreexamineeach bench- rectly. This is quite a commitment, but necesmark on an annual basis to see if changes are sary if you want to receive the benefits of the
required. Historically, the changes that have process.
been made have not been that significant. This
suggests that, for us, transactioncosts may not
Multiple Benchmarks for a Firm
be a big issue for all our investment managers.
Should an investment manager have one
Transaction costs should be considered, how- benchmark for all clients? While this policy
ever, when turnover is high and represents a would minimize client-servicing efforts for the
investment manager, we do not automatically
significant portion of the benchmarkvalue.
agree with the idea. Portfoliomanagers within a
firm often have styles different enough to call
Rebalancing
A benchmark portfolio should be rebalanced for differentbenchmarks.
as frequentlyas requiredto maintainthe desired
Consider, for example, the "star" portfolio
characteristicsor factor exposures, but consid- manager who handles all the larger accounts of
eration must be given to the transaction costs the firm. This managermay be forced out of the
FINANCIALANALYSTSJOURNAL/ SEPTEMBER-OCTOBER
1990El 24
Low-P/E Active Exposure and Return
small companies typically held by the other Figure H
selection
portfolio managers in the firm. His
1.5
universe would thus differ from that of his
fellow managers.
_
~~~~~ReturnThese issues have to be studied. Blind accep.:
1.0
tance of a benchmark can lead to less than
Exposure
optimal results.
Investment Horizon
A common misconception is that performance
evaluation based on benchmark portfolios will
automaticallyallow you to judge an investment
manager's overall abilities in a shorter time
frame than you would need using traditional
comparativestandards such as the S&P500. We
do not believe that this is so. Customized benchmarks can better differentiate returns due to
investment style from returnsdue to investment
strategies, but the time it takes to make overall
assessments is still dependent on the manager's
investment strategy and its time frame.
An investment manager with a two to threeyear horizon making a large bet on a particular
sector, such as technology, is not making a
decision that can be evaluated on a quarterlyor
even an annual basis. The benchmarkportfolio
process can be used to monitor the bet's impact
on portfolio risk and returnwhile the strategyis
"in play" and to alert the managerto the client's
view of the strategy's success. Overall assessment of the strategy, however, requires a time
horizon that coincides with the investment process. Of course, an investment manager that
expects its strategies to pay off within a relatively short time can be evaluated over a relatively short time horizon;this type of manageris
easier to monitor and evaluate using the benchmark portfolio process.
Another common misconception, related to
this issue, is that the benchmarkportfolio process favors quantitative investment approaches
over more traditional, qualitative approaches.
This is not so. The issue is not the type of
investment approach (i.e., quantitativeor qualitative). The issue is the investment horizon.
Lack of Standards
There are no standards for defining an investment manager's benchmarkportfolio. There are
guidelines for the process, but these guidelines
are sufficiently flexible to lead to confusion,
controversy and misleading results.
The key to designing an acceptable benchmark is understanding and defining the risks
E
0.5
0
-0.5
-1.0
iiIuiIIh
Jan.86
Ip
IEIIIa
ahaIaIal
Jan.87
Jan.88
a
you feel the investment manager is taking as
bets and those that are present but associated
with investment style. Bets should not be reflected in the benchmark. If they are, the manager will not receive proper credit for the outcome of its insights. Sometimes, however, it is
very difficult to determine what is a bet and
what is style.
One of the issues that has raised the most
controversy when constructing benchmark
portfolios is the E/P exposure. Over the 39month period ending December31, 1988, one of
our investment managers maintained a 0.30
standard deviation active exposure to low-P/E
securities relative to its benchmark portfolio.
This means the manager had a bias toward
stocks with a lower P/Ethan its benchmark.This
active exposure was fairly stable, varying only
0.07 standarddeviations over the period. Figure
H highlights the monthly active exposure and
the investment return associated with the exposure.
The investment manager's total active return
for the period was approximately3 per cent per
year. Of this return, approximately 2 per cent
was attributable to having the 0.30 average
active exposure to P/E.
The P/E exposure can be treated in two ways.
It can be considered an active management bet,
for which the investment manager should be
given credit. Alternatively,because of its length
and persistence, it could be considered a style
decision and included in the benchmarkportfolio. In this case, the investment manager would
1990O 25
FINANCIALANALYSTSJOURNAL/ SEPTEMBER-OCTOBER
not receive the credit for the decision. The two
approaches lead to two very different benchmark portfolios and results.
Because there are no standards, there are no
"right" answers to this question. We have discussed the issue with several people and there
are good arguments on both sides. We continue
to give credit for the decision, but are considering alternatives.
Anomalous Market Periods
Finally, what happens to the process, and
what do you do, when investment returns do
not appear to be related to the same factorsthey
were related to in the past? As RobertC. Jones
noted in the GoldmanSachsPortfolioStrategyof
December 1987:
Nothingworkedin 1987.Not one of the stockselection systemscoveredin this publicationhad significant positive results last year;many had negative
of all activemanagresults.Similarly,three-quarters
the marketin 1987.Valueapers under-performed
proaches, growth approaches, high yield approaches,and even aggressive,emerginggrowth
approachesall underperformed.
This was confirmed by our benchmark portfolio process. In 1987, most of our investment
managers underperformed their benchmark
portfolios even though they did not change a
thing in their investment processes. Does this
mean that the investment managers are poor?
We do not think so. We think 1987 was an
anomalous year, and that it needs to be given
special consideration in a benchmark portfolio
analysis.
These are especially criticalissues that need to
be considered as the use of benchmark portfolios for incentive fees increases. Historically
skillful investment managers were really at a
disadvantage in 1987.
Conclusion
Despite all these problems, should you use
benchmark portfolios? We believe so. The
benchmark portfolio process is another investment tool to help evaluate an investment manager more effectively. It is a valuable tool, however, because it provides information about an
investment manager's sources of returns and
risk. In addition, benchmarkportfolios provide
information from a different perspective than
most of the traditionaltools currentlyavailable.
Like all tools, however, the benchmark portfolio process can be misused and misinterpreted. That is why it is important that it be a
cooperativeeffortbetween the plan sponsor, the
investment manager and the assisting consultant. It is also very important for the individuals
involved to be familiarwith the process and the
problems we have addressed and to monitor
and adapt the process as required over time. E
FINANCIAL ANALYSTS JOURNAL / SEPTEMBER-OCTOBER1990 a 26