Chapter 23

Reviewing

Are you on track to achieve your objectives?

‘True genius resides in the capacity for evaluation of uncertain, hazardous and conflicting information.’

Winston Churchill

We are at the final stage of the investment management process: reviewing. After setting objectives, formulating an investment strategy and implementing a solution, it is time to review everything. Assess how the portfolio is doing and whether anything needs altering.

The first objective of reviewing your portfolio’s performance is checking whether you are on track to achieve your objectives. Given performance, decide whether you need to adjust your strategy or objectives.

If performance is ahead of objectives and you have accumulated more than planned up to this point, consider either reducing risk since you require lower returns going forward, or increasing risk because you are able to absorb higher losses.

If performance lags objectives, consider either increasing risk because you need higher returns to achieve your goals, or settle for more modest objectives. Differentiate between required and desired goals when deciding.

This is path-dependent dynamic risk budgeting. Think about changing the target value of your portfolio at retirement – higher if results are better than planned, lower if worse. The decision depends on the remaining time to retirement. A long time allows to raise risk, while a short time probably means adjusting expectations downward.

Reviewing’s second objective is to understand where performance is coming from. Is it SAA, active asset allocation or security selection in your active funds?

Adapt your philosophy and strategy, based on results. If you consistently add value through active asset allocation, perhaps you are skilled and should continue doing it. If you consistently destroy value, perhaps stop doing it. If your selection of active funds adds value, consider continuing to use active funds. If they underperform, consider switching to trackers.

Reaching conclusions requires time. A couple of years of good or bad performance are not sufficient to draw any meaningful conclusions about your talents and track record. Performance should, ideally, be assessed over a full economic cycle.

When comparing funds’ performance, ensure it is measured over the same time period. Some DC platforms show fund performance, but it is measured since you bought each fund, not over the same period. Compare likes with likes.

High frequency reviewing is appraising performance often (such as daily or weekly). It can cause undue stress, leading to rush decisions. For example, you might decide to sell a fund just because it underperformed recently. However, managers need time to deliver performance. Judging performance over a short time can be counterproductive.

On the other hand, review performance periodically. Reviewing your portfolio once a quarter is a good frequency for an overview. But it is too short to make decisions on buying and selling funds.

Benchmarks and benchmarking

Benchmarking is measuring performance against some standard. For example, is a return of +10% good or bad? Well, it depends. Against a benchmark of +5% it is good, but against a benchmark of +20% it is bad.

When managing your portfolio, use three benchmarks. The first is the most important: your investment objectives. Compare return against your return objective, as well as risk against your risk objective.

The second benchmark is your SAA composite benchmark. It measures your SAA’s performance without active asset allocation or security selection. It helps to measure whether your actual portfolio performs in line with strategy. It shows whether your actions, like TAA and fund selection, add value.

The third benchmark is comparing each fund you select with its benchmark. This allows monitoring whether the funds you are using deliver. Each benchmark should fit each fund’s style (for example, a value equity fund should be compared to a value equity index).

Peer group benchmarking

Often, active funds’ performance is compared to that of peer groups – the median or average performance of all funds in a category. Whilst peer comparison is helpful to rank managers, your default choice is trackers. Consider active funds only if they are likely to outperform index trackers. The appropriate benchmark for active funds is trackers, not passive indices. The latter are not directly investable.

For example, you are contemplating buying a UK equity fund. The peer group median return is 5%. A fund you consider returned 10%, putting it in the top quartile amongst peers. However, an ETF tracking the FTSE 100 Index returned 15%. The fund is good compared to other active funds, but, during the specific time period, most active funds underperformed the passive index. You are paying extra fees for an active fund to do better than trackers, not to do better than peers.

Nevertheless, peer group comparison can help to identify managers with potential skill. Perhaps, during specific times, all managers struggle to outperform the index. However, in other times, good managers can outperform.

Morningstar publishes an active/passive barometer. It can help you to understand during which time periods and for which asset classes active managers generally do better or worse.

Summary

• The first objective of reviewing performance is confirming whether you are on track to achieve your objectives.
• Path-dependent risk budgeting means changing risk level based on results.
• Reviewing is used to understand performance’s drivers to adjust your strategy accordingly. Focus on what you are doing well – buy-and-hold SAA, active asset allocation or selection of active funds.
• Do not rush to reach conclusions based on results – ideally, assess results over a full economic cycle.
• Benchmarking puts performance in context.
• Peer group benchmarking helps you to spot potentially skilful managers. However, you pay a fee for active funds to outperform index trackers, not to outperform other active funds.