The U.S. stock market rally over the last five-and-a-half years has led to impressive returns across nonprofit investment portfolios. While it is easy to become complacent in a period of outsized returns, fiduciaries must ask themselves two critical questions:
• What is the source of these high returns and are they sustainable?
• Is recent performance the result of superior asset allocation and manager selection, or simply a rising tide lifting all boats?
Importance of Benchmarking
Fiduciaries are concerned with growing the assets of their foundation or endowment. Over the last five-and-a-half years, many organizations have seen that goal realized, as the U.S. stock market, international stock markets, global bond markets and real estate have all offered impressive returns. In fact, many organizations have been able to fulfill their spending requirements and still realize substantial appreciation of their portfolio. While it is easy to get comfortable when portfolios continue to grow, fiduciaries should work to ensure that their organization is maximizing opportunities. But how can a nonprofit determine if they are truly maximizing the opportunities in the markets? The answer comes from portfolio performance attribution through relevant benchmarking.
Establishing a benchmark is critical for many reasons, the most important of which is understanding the source of performance. For example, an investment portfolio may earn a return of 10% in a given year. A 10% return allows the organization to meet all budgeted spending requirements, keep pace with inflation, and experience real growth. However, over the same period a collection of stock and bond indexes that match the targeted allocations within the portfolio returned 15%. Fiduciaries might reward investment managers for the perceived success coming from the 10% return, when in reality the manager is failing to add any value through security or fund selection. Without understanding the endowment or foundation’s performance relative to a carefully selected benchmark, the long-term performance of the organization could be compromised.
Selecting the Right Benchmark
Before an organization determines an appropriate benchmark, it must first consider the asset allocation decisions. The initial asset allocation discussion determines the markets and asset classes that are appropriate to include in the investment portfolio. The discussion should concentrate on proper risk mitigation through diversification, but also focus on ensuring that each asset class serves a particular purpose within the portfolio. Once the initial asset allocation discussion is complete, the next step is to determine how to invest in each asset class. Selecting an asset class benchmark is the first part of that process.
When choosing the proper benchmark, there are several factors to consider:
- A benchmark should be investable. The benchmark should contain publicly-traded securities and should be replicable. A benchmark that can be replicated will typically lead to several low-cost passive fund options that seek to track performance of the benchmark. Having such availability provides an option for index-like exposure to the asset class, which is generally a different type of exposure from an actively managed strategy.
- Historical data should be available. Having historical data available allows investors to understand the risk and return profile of the allocation over multiple time periods and various market cycles.
- Industry use. It is important to consider how widely a specific benchmark is used by investment managers. Benchmarks that are more widely used by investment managers normally result in more available investment options using active strategies.
- Benchmark holdings should reflect targeted exposure. A benchmark should represent the types of exposures an investor is looking for within an asset class. For example, an investor who is looking to invest in investment-grade fixed income, but does not want any exposure to mortgage-backed or asset-backed securities, should select a benchmark that does not have these exposures. Likewise an organization that does not wish to be exposed to fluctuations in foreign currency exchange rates would select an international equity benchmark that hedges any foreign currency risk.
- The benchmark should be purposeful. If an asset class included in the portfolio has a specific purpose, then the chosen benchmark should accomplish that purpose. For example, some organizations choose to allocate to international equities in emerging markets as a way of enhancing total portfolio returns. A benchmark that only tracks the performance of large, stable, international companies would not be a fit, as it likely would not accomplish the intended purpose of the allocation.