There’s a myriad of ways to measure performance.  We’re not going to advocate one over another but present this information as one possible way to measure results.  This is not theoretical, it is our preferred method to discuss risk-adjusted returns when we sit down with investors.  Specifically, to measure the value of the investment process at Sewickley Financial.

 

Percent Return 

The following is a simple percent return on an investment or investment portfolio over a given period:

% Return = (Change in Value + Income) ÷ (Original Investment Amount)

Where income includes only monies received associated with the Original Investment Amount.  For purposes of discussion, any cash flows received or distributed which are not associated with the investment(s) are not included in the above figure.*

 

Benchmark Return 

We then consider if the % Return appropriately met or exceed its benchmark return for the period considered.  This Benchmark return is calculated as follows:

Benchmark Return  =  [(EA÷OIA) × (S&P 500 % Return)]  +  [(FI÷OIA) × (Barclay’s Aggregate Bond % Return)]  +  [(Cash÷OIA) × (Money Mkt % Return)]

Where  OIA = Original Investment Amount        EA is Original Equity Amount           FI is Original Fixed Income Amount

Note in both cases the % Return stated for S&P500 & Barclay’s Aggregate Bond the returns are total returns (inclusive of dividends).  Also, note that that there are many other indexes that can be used here.  Even in the case of adding international stock & bond investments we consider the benchmarks to be those we find “close to home.”  Again, we are not advocating one method over another, it is simply preference in part influenced by discussions with our investors.

An investor can get lost tracking down benchmarks.  Our preference is to keep it simple & focus on maximizing risk-adjusted returns.

Example 

So here’s an example of how we would measure that.  In the 1st Quarter of 2015, the S&P 500 returned 0.44%, the Barclay’s Aggregate Bond Index returned 1.19% and Brokerage Money Market 0.0025%. Therefore, the Benchmark Return for an investor who started the year with a 70% stock, 20% bond, and 10% cash allocation would be:

Risk-Adjusted Benchmark Return 1Q15 (70%/20%/10%)   =   [.70 × 0.44%] + [.20 × 1.19%] + [.10 × 0.01%÷4]

         =  0.546%

Measuring Value of the Investment Process 

We would then look at the Investment Portfolio’s Return relative to this 0.546% . What we’re essentially looking for over time is: does the return exceed the Risk-Adjusted Benchmark Return?

 

Considering Beta 

If you’d like, you can add beta (ß) of the Equity Investment Portfolio to this equation….

Benchmark Return  =  [(EA÷OIA) × (β × S&P 500 % Return)]  +  [(FI÷OIA) × (Barclay’s Aggregate Bond % Return)]  +  [(Cash÷OIA) × (Money Mkt % Return)]

But we’ve found βs for individual financial instruments to be inconsistently reported and applied. This is due in part to the fact that β is dependent on it’s point in time & referenced time period. So, we tend to avoid relying on β to add to the argument. Most investors can appreciate the intuitive aspect of lower β.

 

Tactical 

There is an important Tactical aspect to be considered as well. The above figures deal with returns relative to risk during specific time periods.  However, there are times at which we find ourselves unconvinced of the risk:reward outlook in the financial markets. In this case, preserving cash or whatever one might call it can be a valid part of an overall investment strategy. The notion of overweighting and underweighting certain asset classes is generally referred to as Tactical Asset Allocation.

You can find a good deal of information on this subject across several different financial websites. To the extent it’s available to you, consider the CFA Institute’s studies on the subject for review. Some like to refer to Tactical Asset Allocation (in the case of choosing cash or money market) as market timing. However, let them begin by going to Omaha and telling a certain gentleman that he should no longer attempt to time the markets. Market timing is generally more of a trading strategy, not an investment strategy.

Any tactical allocation which you choose to pursue with your advisor should be measured in light of what you consider over a long time period to be your optimal allocation relative to your risk tolerance. It can get very complicated (you might trip over some detailed academic studies if you’re not careful). But, we like to keep it fairly simple.

Here’s how we measure it at Sewickley Financial. Say an investor indicates his/her optimal risk-adjusted return allocation is 65% Stock, 20% Bonds, 5% Cash over the long-term but that he/she is willing to sacrifice potential upside during periods of greater uncertainty. In this scenario, Long Term Benchmark Return would be calculated as follows:

Benchmark Return(Long Term)  =  [(65%) × (S&P 500 % Return)]  +  [(20%) × (Barclay’s Aggregate Bond % Return)]  +  [(5%) × (Money Mkt % Return)]

Note in both cases the % Returns stated are total returns (inclusive of dividends). Again, you can choose from many other benchmarks. Make sure to choose something that is acceptable to you from a risk:reward standpoint.  And make sure the indexes are attainable, measurable, and appropriate.

 

Example

So here’s an example of how we would measure that. From January 1st of 2007 to December 31st of 2014, the S&P 500 returned 72.3983%, the Barclay’s Aggregate Bond Index returned 48.2464% and Brokerage Money Market 4.071%. Therefore, the Benchmark Return for an investor whose long-term risk-adjusted return allocation was 65% stock, 20% bond, and 5% cash allocation would be:

Risk-Adjusted Benchmark Return ’07-’14 (65%/20%/5%)   =   [.65 × 72.3983%] + [.20 × 48.2464%] + [.05 ×4.071%]

         =  56.9117%  (or 5.793% annualized)

The level to which an advisor can work with an investor to manage Tactical Allocation & bring value relative to the benchmark can be very meaningful.  For instance, the psychological impact of being underweight an equity index when equities move higher can be considerable. But the damage done by being fully invested when equities have a very volatile move downward can be quite a bit greater. Think of some of the discussions you might have had in 2008; the general fear and the inability for many investors to stick to a long-term plan.

At Sewickley Financial we look for the annualized return in the above Tactical Analysis to be greater than 5.793% plus the annual advisor fee. This is a simple long-term measure of adding value for the client. Academic arguments can be made to attempt to discern the Tactical impact relative to the Investment Process impact, however the result and the value to the client are the critical features.

* An investor & their advisor should agree beforehand how to handle cash flows into & out of the account which are not a direct result of the investment decisions and/or fees. This will provide for clearer analysis & discussion.