Using benchmarks for charity investment portfolios

The uses of benchmarks are frequently misunderstood and terms are often mixed up leading to widespread confusion.

Benchmarks are used for three main purposes:

1. To set constraints on the types of asset and their proportions held in a portfolio
2. To set targets to beat
3. To provide a comparator of similar strategies or client types

Composite market indices

Typically combines a series of market indices in similar proportions to the portfolio’s long-term strategic asset allocation. Assets held can be mapped to long-term liabilities or required returns to help determine the long-term risk and return objectives.

Target return (also known as absolute return)

Measures portfolio progress against a fixed yardstick, for example, consumer price index (CPI) plus 3%. It is important to remember that this is a longer-term benchmark, most often used as a target to beat and is less appropriate over short periods or in providing comparative data.

Peer group

Looks at average performance of a group of charity funds, for example, ARC charity indices. This can be a useful sense check to see how your portfolio is performing compared to others. However, these benchmarks often do not consider the bespoke objectives of a charity, their ethical constraints and can group together portfolios with very different asset allocations and investment approaches.

Peer group benchmarks were the first type of benchmark to become popular. But only return was considered, irrespective of the risk taken. This realisation often encouraged fund managers to take on more risk in a race to the top of the table. The result was that in the inevitable down-turn portfolios proved to be riskier than trustees were comfortable with.

Previously, the greater use of composite index benchmarks looked like an ideal solution. However, trustees began to monitor achievement of their long-term objectives on increasingly short time frames. Inexperienced investors tended to buy managers at the peak of their out-performance and then sell-out at their trough, therefore damaging investment returns. In turn, investment managers learnt that it was safer in terms of mandate retention to tightly (‘closet’) track the composite benchmark. This led to returns that failed to outperform the composite.

In recent years, we have seen increased use of the target return benchmark. However, this can lead to long periods of lower returns than the market and leave trustees wondering whether they made the right decision to only track CPI plus 3%, when the performance of markets has averaged so much more.

Each of the three types of investment benchmark discussed captures desirable characteristics that trustees would want to encourage and monitor in a portfolio, however the focus on just one benchmark invariably leads to other desirable portfolio characteristics being neglected. As there is no single solution, best practice is to use a combination of all three types to reflect the uses to which each is best suited and to provide points of differentiation for discussion.

This approach helps provide a balance of desirable characteristics being monitored and encourages both the trustee and investment manager to pay close attention. While this approach does not provide a hard and fast test of success and failure in the short term, it does help ensure that everyone is more focussed on what really matters through the whole investment cycle.

Our charities team can help you use benchmarks effectively. For more information, contact a member of the charities team.