Client Communications

Interim Report - Thoughts on Benchmarking (Part 1) - July, 2012


In the investment field, a benchmark portfolio is a structured index portfolio of securities created by a benchmark provider that is generally representative of a particular investment market.  The S&P 500 Index, for example, is considered to be a benchmark for the U.S. stock market.  Its information value to an investor is in being a convenient way to glean an understanding of how the entire U.S. stock market is generally performing through the lens of a single index number.  Since we are balanced managers for you, owning a combination of stocks, bonds, cash, commodity funds, etc., we now have a specific benchmark index portfolio for each asset class which, in combination, creates your Policy Benchmark

Portfolio managers generate account performance which typically fluctuates around their selected benchmarks, sometimes beating it and other times underperforming it.  From a long-term perspective of say, greater than five years, the odds of beating any benchmark on a cumulative basis continue to diminish as the compounding effects of trading costs, administrative fees,  and account management fees take an ever rising toll on relative performance.  This is the case because benchmark indices themselves have no trading costs or operating expenses.

So, if long term active management outperformance relative to a benchmark is pretty much a non starter, it is reasonable to ask how one should determine if a manager’s performance falls within acceptable boundaries of investment return.  We’ll tackle that topic in Part II of our benchmarking discussion in our next quarterly report.  For the balance of this report, our intention is to introduce the various features of benchmarks and to present several thoughts regarding the benefits and limitations of portfolio benchmarking. 


There’s an understandable expectation among many investors that a portfolio manager’s job is to beat his or her benchmark over some agreed upon period of time.  This may be a reasonable assumption if one were simply selecting an actively managed mutual fund whose performance objective is defined relative to a particular benchmark index.  After all, an investor could simply purchase an index fund if all they wanted is index fund performance (less fees).   But, by making the decision instead to employ an actively managed approach, one’s expectation could be to earn a return greater than the associated benchmark index.  Otherwise why incur a fee for active portfolio management?  Please read on!

In contrast to this line of reasoning, we want to dispel any notion that SIMI’s purpose in managing client portfolios is simply to beat the benchmark index for each of your asset classes.  We don’t manage portfolios in a manner which attempts to beat any benchmark.  It’s not our mandate in our clients’ Investment Policy Statement (IPS).  Our mandate is instead, to help each client achieve long-term individual investment objectives.  Portfolios simply aren’t constructed or managed to be in a foot race with any benchmark index.  While it is true that portfolios are structured to be generally representative of each selected benchmark, we incorporate many specific traits or tilts to these portfolios  which serve to disqualify many of the securities contained in the benchmark index.  Of course, we hope that our customizing actions will lead to portfolio relative outperformance, but markets don’t always cooperate.


Consider the following regarding benchmark stock market indices:

  1. The major stock market indices are typically constructed on a capitalization weighted basis, meaning that the largest companies by total market value comprise the largest percentages of the index.  Client portfolios, however, are constructed on a more or less equal-weighted basis and contain a very small percentage of the stocks found in the benchmark index.  Furthermore, we are not constrained to owning only those securities contained in our equity benchmark.
  2. Indices have no guidelines as to how large individual positions can grow in a momentum-driven market.  We, on the other hand, in the interest of prudence, will trim back a security position the more “overvalued” (in our opinion) the security becomes – or the more disproportionate it becomes relative to clients’ other investments.  This means we may be cutting short the remaining upside of a rapidly rising security simply because our concept of valuation is being violated.  We take this action because a disproportionately large security position in a client’s portfolio may eventually create a very uncomfortable level of volatility in investment returns.  In the benchmark index however, the same security will have negligible impact on volatility, being just one small component within a substantially greater number of securities.
  3. Indices will typically contain many securities which, for a variety of reasons, we deem to be inappropriate, or even imprudent, for our clients.  Many factors come into play here: Company size, company leverage (amount of debt to equity), dividend policy and management’s ability to add shareholder value, to name but a few.  Nevertheless, from time to time, companies which don’t meet our investment criteria may significantly outperform the rest of the market, adding disproportionately to benchmark index return.
  4. Equity indices represent more or less static portfolios of securities; there’s not a lot of turnover per year.  The securities in the S&P 500 Index aren’t adjusted, if for example, Greece is expected to exit the Euro Zone with seriously negative contagion consequences to the global banking system.  Our clients, on the other hand, rightly expect that we shouldn’t potentially jeopardize the value of their portfolios if the Greek situation doesn’t have a favorable outcome.  Indices are infinite-lived vehicles; our clients, unfortunately, are not.  So, we take positions of a defensive or offensive manner in client portfolios regarding situations which may or may not materialize, and which indices ignore.  Then we adjust portfolio holdings as subsequent events prove our various assumptions either correct or incorrect.
  5. Since we are global equity managers, we have chosen the MSCI All World Index to be the benchmark for the equity portion of your portfolio.  As a result, additional influences beyond individual company performance influence index performance.  Principal among these are currency influences, country economics, and political influences.  In sum, the number of index-influencing variables on a global equity index defy the calculating power of today’s most advanced computers to accurately model all future outcomes and associated probabilities.


On the fixed income side there are additional issues for investors to ponder.  The most common characteristic of bond indices or benchmarks is the fact that their composition is constantly changing as older bonds mature or are redeemed early and newer ones are added.  This has an impact on the benchmark’s average yield to maturity, coupon rate, and average credit rating, in addition to other more technical characteristics.  Industry composition among the holdings ebbs and flows.  In the case of our fixed income benchmark, the U.S. Investment Grade Corporate Bond Index, bonds may enter or leave the index as their credit ratings change.  The index thus takes on the characteristics of a moving target over time.  We on the other hand, wouldn’t sell a bond from a client portfolio due to a ratings change unless we concluded that return of principal at maturity of the issuer has been jeopardized.  We also select an approximate average maturity range for bond portfolios that we deem appropriate for our clients, but that may differ from that of the index.


From a philosophical standpoint, the price action of any securities market – and therefore the benchmark index designed to capture that price action – reflects the extraordinarily varied interests of all the participants in that market each day.  There are those who, for example, are momentum based “day traders.”  They couldn’t care less about earnings quality, long term corporate objectives, dividend yields, etc.  Their investment time horizon can be as short as microseconds; perhaps as long as a day.  We mention this point because today, very short term trading represents a significant percentage of daily stock market volume, but the resulting security price movements from this contingent of stock market participants simply isn’t relevant to SIMI’s clients.  On May 6, 2020 for example, the Dow Jones Industrial Average experienced a 1,000 point “flash crash” in which computer generated trading engineered a rapid downturn in prices followed by an almost as rapid price recovery.  This volatility might have been a day trader’s dream (or nightmare), but from the standpoint of our clients it was a non-relevant occurrence.

Other market participants may have investment timeframes of weeks or months while our time frame as defined in each client’s IPS, is in terms of years.  The point here is that in spite of dramatically different goals, objectives, timeframes, etc.; we all enter the same marketplace to actualize our vastly differing investment objectives.  The performance actions of our benchmarks are clearly influenced by factors having nothing to do with our personal investment objectives.  Therefore, in the short term of a calendar quarter or even a year, a comparison of the performance of a client’s portfolio relative to a benchmark may have little or no valuable information content.  Our industry generally acknowledges that a 3-5 year timeframe is a more appropriate time period against which manager performance should be measured and compared to appropriate benchmark indices.  Such a timeframe allows for shorter-term influences to dissipate out of performance results.

One final observation about operating costs bears mentioning.  Indices operate in an almost “friction-free” environment.  By this we mean there are no trading costs, no advisory fees and no penalties for illiquidity regarding thinly traded securities.  Active managers, on the other hand, incur all of these trading costs, and more.  It is the compounding of these costs which makes it increasingly difficult to outperform any benchmark with the passage of time.  It’s true that, from time to time, lucky bets by a portfolio manager in as little as one time period (one quarter, for example) may result in significant outperformance relative to a benchmark that carries forward in return calculations for some number of future time periods on a cumulative basis, perhaps as long as a few years.  But, just like the inexorable pull of gravity on objects operating in the earth’s atmosphere, eventually the compounding costs of active portfolio management pull manager performance down to levels below that of their benchmarks.  A hypothetical illustration of the one-time verses cumulative time period effect will clarify this point (See EXHIBIT 1The Curious case of the outperforming, underperforming portfolio manager).

As a result of these items, as well as others which if listed would cause this piece to be entirely too long, the insight into benchmarking which we seek to impress upon our reader is this:  Asset class benchmarks are simply guideposts around which clients’ respective asset classes should perform within a “reasonable” proximity.  The static structure of an equity benchmark allows the client and manager to discuss the reasons for differences in performance and allows for insights into the manager’s investment decision making process.  It can then be demonstrated that relative outperformance doesn’t necessarily imply an extraordinary manager skillset, nor does underperformance imply a sudden loss of manager capability.

 EXHIBIT 1—The curious case of the outperforming, underperforming portfolio manager.  In the chart above our hypothetical money manager significantly outperformed the benchmark index in year one.  Thereafter, in each of the years 2-10, the manager underperformed the benchmark.  The manager’s first-year outperformance was of such significance however, that on a cumulative basis the manager could correctly claim to have outperformed the index each year until the end of the eighth year when the cumulative index return finally pulled ahead of the manager’s cumulative numbers.

For this manager to tout his market-beating cumulative performance during years two through seven might be great for marketing purposes.  But not one single client who signed up after year one results were announced would receive market-beating returns.  Finally, it is highly unlikely that the “bet” the manager made in year one that worked out so well is a repeatable event.  Every investor should always remember the well-worn phrase:  “Past performance is not indicative of future returns.”


Fair questions at this point are “If active managers can’t regularly outperform their benchmarks why bother with active management at all?  Why should I not just buy index funds and forget about trying to pick managers if the odds are that they can’t be expected to beat their benchmarks?”  And, as asked at the beginning of this piece, “Why pay active management fees for likely long term under-performance relative to indices?”  The field of behavioral finance gives us the answers:  Humans are not computers.  People are burdened with all kinds of biases which interfere with rational, objective  behavior.  Examples of often-repeated harmful investor activity include panic selling at market bottoms or stampeding in at market tops.  Overconfidence and linear thinking (recent events will continue into the future) are also near the top of the list of biases.  Our investment literature has documented ad nauseum the truly shocking rates of investor under performance relative to both index funds and managed investment products when individuals manage their own portfolios.  Simply put, we as individuals are not biologically wired to react correctly to erratic and volatile market behavior.  Skilled and experienced portfolio managers, on the other hand, are at least equipped with a sense of perspective that may enable them to guide clients through the emotional extremes which investment markets evoke.

 Finally, a reader may ask, why bother with benchmarks at all?  The most basic reason is that the creation of any portfolio needs some frame of reference for a starting point, and industry best practices as well as fiduciary obligations call for diversification as a risk control measure.  Thus investors or their money managers need some type of a framework upon which a portfolio can be built, continuously managed, and compared to on a performance basis.  Hence the need for a benchmark.

Please consider that SIMI is managing its clients’ money pursuant to their investment philosophy as set forth in Investment Policy Statements that explain how they expect active management to add value to their portfolio.  In this sense the client as the investor should feel comfortable with each asset class benchmark.  Their composition and characteristics should be in alignment with clients’ investment objectives.  SIMI, as its clients’ investment manager, makes active decisions regarding which securities and risk factors to over/underweight in order to generate “active” returns relative to benchmark indices.  These active decisions can then be analyzed with the benefit of hindsight to determine if value has in fact been added.  Periodic comparison to the performance of the benchmark gives us a feedback mechanism with information that allows for continuing refinement of our investment process via-à-vis your needs and objectives.

In many cases, value includes an intangible and immeasurable element:  The relief that comes with knowing that the investment professional is providing a service in a complex and often overwhelming market environment. 


Roger A. Sheffield, CFA
Sheffield Investment Management, Inc.                              
900 Circle 75 Parkway, Suite 750                          
Atlanta, GA 30339
(770) 953-1597
(770) 953-3586 (fax)