Dan Williams, CFA, CFP, Investment Analyst

A common, yet hard to answer, question for clients is “how are my investments doing?” By definition, the answer lies with benchmarks as a frame of reference but the semantics of their proper use often proves to be a stumbling block. Do you use a single broad index such as the S&P 500? Do you look at a risk equivalent blend of multiple broad indexes? Do you just look at the absolute return number? Additionally, do you look over the quarter, the year, or the decade of performance? Often the best way to properly use benchmarks is drilling down the context and the intent of this seemingly simple question.

This is to say, if the question is to assess how an investment portfolio is performing in the context of the current market environment, a blended benchmark of the neutral weights of a portfolio over a short time period is best. This is to say if you are looking at a large cap growth stock fund, you could look at the Russell 1000 Growth Index over the past quarter or year. If you wanted to judge a moderate risk portfolio with a neutral weight of 60% equity and 40% fixed income, you would turn to a blended benchmark of the same risk level over a similar period of time. However, while this shows how the portfolio is relatively performing currently, this comparison will serve as a poor judge of the true skill of the portfolio managers. Market conditions in the short-term favor different styles of investing over others. These preferences wax and wane over time with skilled managers proving their worth through the long-term of multiple market environments rather through every market environment.

As such, if the question is instead to evaluate the skill of a portfolio manager, the answer requires a much more rigorous analysis. You would like to see skill over various market environments and not just the current market environment. Accordingly, one of the many statistics that we look at is the percent of rolling 36-month periods that a strategy has outperformed its market benchmark. It is unreasonable to expect a strategy to outperform all such 3-year periods but a skilled manager should hope to do so more often than not. Additionally, looking at 7-year or longer time horizons provide a clearer view of how a manager faired after the dust has settled over one or more market cycles. As always looking at past performance only provides evidence of past skill and not necessarily future skill. The complete manager due diligence process extends beyond the numbers and requires additional work with regards to the qualitative characteristics of the managers and their organization.

A final way for this question to be asked is what should be most meaningful to the client. Specifically, how are the investments doing with regards to accomplishing the clients’ financial goals? Here we leave the market-based indexes behind and instead look to the absolute return numbers to determine if purchasing power is growing at a pace consistent with the investments savings goals. The time horizon of the evaluation should be consistent with the time horizon of the goal. In practice, a conservative portfolio that strives to deliver 3-5% a year for a goal that is 3-4 years away, should be evaluated by whether after 3-4 years if this return mandate is met. Similarly, an aggressive portfolio that strives to deliver 7-9% for a goal that is more than 10 years in the future should be evaluated over a period of at least 10 years against this return mandate. These return mandates could be further tweaked to be a spread in excess of inflation or a risk-free rate as clients’ goals are best defined as a growth in purchasing power rather than just a raw performance number.

It is clear that there is no one right way to tell clients how their investments are doing. Hopefully though helping clients define their “how are my investments doing” question can improve the relevance of the benchmarks and time horizons used to give an answer.

The views expressed are those of Brinker Capital and are not intended as investment advice or recommendation. For informational purposes only. Brinker Capital, Inc., a registered investment advisor.