Benchmarking – An art or a science?

on Apr 15, 2015 in Home, Portfolio ad hoc | 1,850 comments

Benchmarking has increasingly become a de facto aspect of most investment programs today. The ubiquitous nature of benchmarks has led index providers to create indices representing just about every asset class, country, and investment style in the market today. With benchmarks covering all types of assets and investment strategies, it makes sense to choose carefully and only after deciding one’s investment goals and risk tolerance. Despite their widespread use for relative performance evaluation, benchmarks still can’t fully evaluate whether an investment program will achieve its ultimate goal: meeting investors’ objectives. Whether investors should benchmark is the easy question. More difficult ones are what to benchmark, and how. In the old days, pension funds basically had the SMI index for equities and the SBI index for bonds. The increase in complexity created a whole new set of issues for investors: how does one go about setting up a benchmark of his portfolio? For asset classes not having suitable market-based benchmarks there has been a rise in popularity of reference-rate plus margin benchmarks. Since this benchmark is not explicitly tied to market cycles, it is best used when evaluating portfolios over a long-term basis. As such, a benchmark based on an absolute target return measure may be consistent with this objective, but absolute benchmarks grow in usefulness as the length of time considered grows – and, conversely, these benchmarks are less useful in assessing short-term performance, as market noise may obscure the longer term performance trends. Reference-rate plus margin and absolute benchmarks have two major drawbacks. Firstly, they are best suited for long time horizons, thus not suitable for investors tracking on a shorter time horizon and are not risk-adjusted. As far as the benchmark suitability is concerned, suppose for instance an investor who believes that the CHF will weaken may choose to invest in securities denominated in other currencies because they will increase in value if the Swiss Franc falls. Under the circumstances, he takes an exposure on foreign holdings and is fully exposed to changes in currency values. He would appropriately use an unhedged index to reflect and track more accurately his positions. However, investors such as pension funds seeking capital preservation or to meet liabilities typically opt for indexes that hedge currency risk (fully or partially) and avoid the volatility that currency investing can bring. Despite the availability of more sophisticated indices, it is up to investors to reflect on how they use them. Benchmarks should be used with a healthy degree of skepticism and additional metrics linked not only to return objectives but also to risk elements including asset quality and development exposure, to monitor the performance. In other words, practices today span the good, the bad and the ugly. Investors, therefore, should engage with their counterpart in dialogue around the inherent advantages and drawbacks of the available benchmark methodologies relative to their investment policies and objectives. Because no true market index exists, investors should be aware of the limitations of various approaches and their possible consequences. Unfortunately, when benchmarks are not appropriately selected, they could lead to decisions that can inadvertently create increased risks. To recap, a fair and appropriate benchmark is an important tool in assessing a portfolio manager’s investment skills. The benchmark construction approach, should let investors build a benchmark that is representative of their portfolio and accounts for the different ways in which a manager can add value. However, the investors should remember the limitation of benchmarks. Whether the benefit is for an institution such as a pension fund, investment portfolios are ultimately designed to meet some future liability. Yet, taken alone, a performance comparison relative or a tracking error to a specific benchmark tells investors nothing about whether their portfolio is positioned to meet its objectives going...

Is it overvalued? Look at the PEG Ratio

on Nov 25, 2014 in Equity, Home, Portfolio ad hoc | 1,820 comments

Many investors rely on popular measures, such as price-to-book value and price-to-earnings ratios. One measure investors like to look at, especially during times of rising stock prices is the price-to-earnings to earnings-growth (PEG) ratio. The price-to-earnings (PE) ratio divides a company’s share price by its earnings per share to give a rough indication of relative value. A relatively low PE doesn’t necessarily translate to an attractive investment opportunity. For this reason, some analysts prefer the price-to-earnings to earnings-growth (PEG) ratio. Believers in the PEG ratio think that the PE by itself is of limited value. Some companies are more expensive, or have higher valuations, than others. But that higher price tag may be worthwhile if the company is growing more rapidly. The PEG ratio is a way to quantify this mindset. The PEG ratio takes a company’s PE ratio and divides it by earnings per share growth. For example, company XYZ has a share price of CHF 40 and earnings per share of CHF 4. This gives the company a PE ratio of 10. If the company’s earnings per share growth is 10%, the PEG would be 1. It’s assumed that a fairly valued company has a PEG of 1. Suppose now that the company’s earnings per share tumbles to CHF 2 and the stock price remains CHF 40. Now, the company’s PEG is 2 assuming earnings growth remains constant at 10%. This implies that the company is overvalued. In other words, investors are paying an unjustified premium given the current growth rate. There are some drawbacks to using the PEG ratio. First of all, XYZ is not going to grow at a 10% growth rate forever. The PEG ratio doesn’t suggest how long the 10% growth rate will persist or what the growth rate is likely to be 5 or 10 years from now. Also, when compared with more detailed discounted cash flow analyses, the PEG ratio tends to undervalue companies with extremely high, almost exponential growth rates. While far from perfect, the PEG ratio still helps gauging relative value. Use it...

Liquid Alternatives, the new Eldorado for active managers?

on Jun 14, 2014 in Derivative, Fixed Income, Home, Portfolio ad hoc | 2,133 comments

Thanks to the unconventional measures of central banks and the march of index investing strategies, we are in fact seeing the rise of a new, more aggressive version of active management. Investment managers are launching investment products that give them more flexibility to roam around financial markets in search of alpha. The question is whether end investors will ultimately benefit from this phenomenon. So, what are exactly Liquid Alternatives? Liquid Alternatives are complex and opaque investment wrappers that require a bit of caution. They are packaged into a fund, covering a wide-ranging category of assets, while using a hedge fund strategy. Unlike most traditional funds, they can go short, use leverage and derivatives. The rise of Liquid Alternatives opens up a vast new market and come at a convenient time for asset managers. Now with bonds looking fairly expensive and equities unstably climbing higher, asset managers are looking for an alternative that could hold its value in dangerous waters. This is where Liquid Alternatives come into play. The risk is that unconstrained funds are not being pitched correctly. They are marketed as uncorrelated assets that increase diversification or act as insurance protection. Faced with a universe of styles and possible strategies, investors ought to be doing their due diligence in a similar fashion as a hedge fund. Consider for instance, fixed income where, after three decades of declining interest rates, the normalization of monetary policy may be a headwind for returns for the coming years. In this respect, PIMCO is pursuing a push for so-called unconstrained bond funds. In practice, the funds are sold as a conservative choice, a prudent alternative to a core bond fund that might no longer be able to preserve capital. It consists of placing bets across a wider spectrum of the fixed income market, such as emerging markets, junk debt, credit derivatives, and taking bets on the direction of interest rates. Retail investors are only catching up with what is happening among institutional investors. This process will lead to more volatility in markets, and be consequently ready to tighten the seat belt. Their record is not long enough to know whether they could get credit for diversification benefits. Don’t forget to do your homework before...

Appetite for smart beta rising?

on Mar 30, 2014 in Home, Portfolio ad hoc | 2,192 comments

An increasing number of investors are moving away from traditional market capitalisation-based indices to alternative strategies, known as smart beta, in search of better returns. Alpha generation, within hedge fund investing has now been shown to be no more than having an exposure to common risk factors. The difficult part is identifying where you get paid as an investor. A paradigm shift is taking place in fund management. For years we have all been indoctrinated in the idea that fund management could either be passive and track an index, or be active and try to beat that index. There is now, however, a greater willingness to steer a middle path that is often described as alternative or smart beta. There is a spectrum of approaches that can be considered alternative beta. Some will be familiar to many investors, including style returns such as value, quality and momentum. Other strategies will be some of the alternative index approaches that have become popular over the past two years. These would include minimum variance strategies that try to achieve the lowest possible volatility, maximum diversification and so-called fundamental indices that weight stocks by accounting measures rather than market cap. State Street Global Advisors has seen a sharp rise in assets under management, in what it describes as smart beta, to more innovative, alternative methods of index construction. More than 40 per cent of investors have already adopted alternative weighting schemes. In fact, the reason behind the new indices for the vast majority of investors is probably the superiority of their performance compared with traditional cap-weighted indices. Everyone agrees that while cap-weighted indices are the best representation of the market, they do not necessarily constitute an efficient benchmark that can be used as a reference for an informed investor’s strategic allocation. However, by moving away from the consensus, investors will be questioned on the relevance of the new model chosen and the evaluation of the robustness of the past performance. Index providers are also experiencing rising demand for alternative or fundamental approaches in which stocks are weighted by metrics such as book value, dividends and sales, or minimum variance where portfolios are designed to reduce volatility. The MSCI smart beta indices turnover varies between 20 per cent, for minimum volatility and value-weighted, to 25 per cent for equally weighted and risk-weighted. MSCI cap-weighted indices average turnover of about 5 per cent. The modest turnovers achieved by MSCI, however, are achieved because it rebalances both cap-weighted and strategy indices only every six months. The appetite for customized or bespoke indices is clearly on the rise. For investors who have decided to move away from market cap, there is still much to...

How to determine the return on your portfolio?

on Jan 27, 2013 in Home, Portfolio ad hoc | 2,200 comments

  In an ideal world, you would be updated semi-annually or annually with your portfolio’s performance, enabling you to compare it to the appropriate benchmarks. In reality, some asset managers may not provide you with the accurate figure! As a matter of fact, deciding on which return measurements should be used is a key element to evaluate the true performance of your portfolio. Below are two of the most commonly calculated return methodologies, which will be discussed in detail. If you want to measure your asset manager success as a decision-maker, meaning how well did his selection of assets perform relative to a benchmark portfolio, use the time-weighted return methodology. On the other hand, if you want to determine how well your invested assets performed, meaning how much your money earned for you during the year, I would suggest you to use the money-weighted return methodology. An investment fund for instance uses the money-weighted return methodology. Mainly because the timing of cash flows into and out of the fund will have an impact on fund performance. Asset managers, on the other hand, are required to use time-weighted return when reporting their performance. Simply because a prospective client or yourself need a measure of the decision-making ability of the manager that excludes the effect of cash inflows and outflows that are beyond the manager’s control. The money-weighted return can differ substantially from the time-weighted return largely on a combination of the following three variables: The timing of the cash flows, the size of the cash flows and the volatility of the portfolio’s market value. The main difference between the two is that time-weighted return ignores the effect of cash inflows and outflows, whereas money-weighted return incorporates the size and timing of cash flows. The money-weighted return internalizes both the timing and size of external cash flows (such as deposits and withdrawals), whereas time-weighted return allows different sub-periods to have different returns. In most cases at portfolio level the time-weighted return methodology is the most appropriate to measure portfolio performance. Primarily to allow comparison between asset managers with different cash flow history. Ask yourself the question, would the investment decisions, asset allocation and investment selections been different, had a different amount of money been available. Almost certainly...

A strategic and tactical asset allocation mix

on Jan 4, 2013 in Home, Portfolio ad hoc | 1,004 comments

Today’s investors clearly face significant challenges in meeting investment objectives, particularly in an environment of relatively modest returns. Identifying and efficiently executing an appropriate asset allocation strategy to meet those investment objectives is important. Neither strategic nor tactical portfolios will shoot the lights out, as they are structured to obtain a specific return for a particular risk over a market cycle which is generally defined as eight to ten years. The primary goal of a strategic asset allocation is to create an asset mix that will provide the optimal balance between expected risk and return for a long-term investment horizon. In other words, there is no attempt on the part of the investors to purposely deviate from the original determined weights. The emphasis is on preserving the fixed weights because they ultimately relate to a larger performance objective. Tactical would be more suitable for investors who want to see the sails of their ships adjusted as the winds change direction. The objective of tactical asset allocation is to move among various asset classes within a risk-controlled framework to seek to create an additional source of return. An attempt is made to take advantage of short and intermediate term market inefficiencies as a means of managing investors’ exposure to market risk by evaluating the relative attractiveness of equity and fixed income markets through financial valuation, growth and sentiment measures. The investment philosophy is usually based on the belief that investor psychology and market forces can lead to periods of misevaluation. A tactical allocation process attempts to capture these misevaluations. In summary, it is fundamental to decide upon an investing strategy, and stick to it. It can be compared to setting a course when starting on a long journey and following it faithfully. On a tactical level, you simply adjust your route only when conditions change. The type of asset allocation strategy that works the best for you then will depend largely on your time horizon and your ability to tolerate risk. I suggest that investors must realize that asset allocation is critical when seeking an investment strategy. They should spend a great deal of time and effort on making sure their asset allocation strategy best reflects their temperament, time frame and objectives. So in the words of the famous saying, conservative investors aim to keep the “bird in the hand,” while aggressive investors seek to gain the “two in the...