Compare the performance (.com) Simples?

What performance benchmark should the private investor use to judge how well his or her investments are doing?

This may seem obvious to some; for equity investments it is common to use the FTSE All Share (as indeed we do with our equity portfolios), but the problem arises with a mixed portfolio, such as our asset allocation approach.

The latter will almost certainly underperform a rising equity market (it will never hold 100% in equities) but this clearly does not mean it is necessarily ‘doing badly’. This asset allocation approach is about achieving good ‘risk adjusted’ returns, ie returns that are less volatile than the equity market.

Even with the FTSE indices as benchmarks for equities there may be a problem of ‘concentration’, ie too few stocks making up a large percentage of the index. The top five stocks in the FTSE 100, HSBC, Royal Dutch, BP, Glaxo and BAT make up roughly 25% of the index. The typical private investor’s portfolio would not have such a concentration, so the FTSE 100 may not be that satisfactory a comparator.It is possible to get round this problem to some extent since the FTSE publish a series of capped indices (where for example the index doesn’t have an allocation of greater than 5% to one stock) although these are not so readily available as the main indices.

The problem with choosing a benchmark, like assessing one’s risk profile which is much the same thing, aside from being difficult to do, is that it may change over time and with circumstances.

Yet, the choice of benchmark may be pretty influential in the eventual investment result achieved. A discretionary fund manager will usually be careful not to stray too far from their benchmark.

The FT run a series of private investor indices (compiled by FTSE International in association with WMA) which they publish in Saturday’s paper. These are ‘Growth’, ‘Balanced’, ‘Income’, ‘Conservative’ and ‘Global Growth.’ These have quite detailed (and to my mind, perhaps overcomplicated), allocations; for example, the income portfolio is stated as being 40% UK equities, 15% international equities,35% bonds, 5% cash, 2.5% commercial property and 2.5% hedge funds. I assume this is a reflection of the samples of private client portfolios that they use to compile the index; hence it is mainly a reflection of the current biases of private client stockbrokers. Nonetheless, these indices can be a useful guide to the performance of an adviser.

So what to do?

It’s not simple. We believe that a benchmark ought to be just that; a test for how well a portfolio is performing. Not necessarily an asset allocation tool. So if we are ‘testing asset allocation’ we need a mixed benchmark; if we are testing equity performance, we need an equity benchmark. In other words, we need to deconstruct performance between asset allocation and asset performance. But also hopefully avoid determining our asset allocation by the choice of benchmark.

With our asset allocation model, we have a steady state scenario (under ‘normal conditions’) of 50% equities, 30% bonds and 20% cash. We think this could act as a reasonable asset allocation benchmark for many private investors, other than those with either a very low or a very high risk tolerance.

But to be clear our asset allocation model is not constrained by this steady state; it can go as high as 80% equities and as low as 0% equities. For those longer term investors who want to keep it simple, the FTSE All Share is probably as good a benchmark as any, just so long as this does not dictate their asset allocation inappropriately.