Understanding and using investment benchmarks

Alan McKnight
Alan McKnight

Alan McKnight

The great challenge of benchmarking is measuring what matters. What matters for a nonprofit is generating financial returns that fully cover spending, inflation and other sundry costs.

If the institution is not covering all of these items, then eventually corpus will be invaded and the institution will no longer be able to meet its mission.

Thus, it is critical that absolute-return benchmarks are adopted in addition to, or even in lieu of, relative benchmarks to ensure that an institution has the ability to deliver on its mission in perpetuity.

For many years, investment benchmarking was as simple as this straightforward benchmark, commonly referred to as “60/40”: 60 percent equities and 40 percent fixed income.

This relative benchmark allowed investment committees to think they had taken advantage of both low- and high-risk portions of the market without further attention needed.

Though it’s understandable that committees cannot constantly monitor the market, setting and forgetting a benchmark is not the best policy for measuring what matters in an investment portfolio.

In 2008, for example, some “good” advisors outperformed the Standard & Poor’s 500 Index by 5 percent. But that year, the S&P 500 was down 37 percent, which means these advisors actually lost 32 percent of their clients’ assets that were invested in equities.

Recently, investment committees have recognized the flaws embedded in the 60/40 benchmark.

Many now have begun to transition to more extensive relative benchmarks that split the 60 percent invested in equities into multiple sub-asset categories, such as large-cap domestic, small-cap domestic, international and emerging markets.

They then split the 40 percent invested in fixed income into multiple sub-asset categories like short duration, long duration, and high yield.

There were also those who added hedge-fund indices to fully reflect the extent of their alternative portfolios.

While significantly better than the set-it-and-forget-it approach, and particularly more valuable when measuring active managers, the more detailed relative benchmark still does not fully measure what matters.

An absolute-return benchmark is more reliable in the new economic reality.

To set a benchmark to measure actual returns, take the long-term average spending policy of the institution (this is easy for private foundations as it always starts at 5 percent), add in an expected inflation component, and finally, include any additional cost borne by the institution.

Then pick an investment manager that is willing to be graded on that number.

For example, a private foundation with a 5 percent spending policy, an expectation of 3 percent for inflation, and 0.50 percent of additional costs would require an absolute return benchmark of 8.5 percent.

While this number seems daunting, and it certainly won’t be easy to achieve, it provides the proper framework for making investment decisions and measuring the progress of the institution’s internal or external investment managers.

It should also be noted that the absolute-return benchmark should be viewed on a long-term basis.

In any given year, it will be more or less valuable due to volatility in the markets. In other words, the board and investment committee should not presume to meet the absolute-return goal every quarter or even every year.

The point is that boards that are under increasing pressure to meet the obligations of their institutions should focus more on benchmarks measuring absolute levels of investment performance, rather the relative-performance benchmarks that have been prescribed by the investment industry for decades.

Alan McKnight is director of Global Investment Strategy at Balentine, an Atlanta-based wealth-management firm with more than $880 million under management. Balentine serves the investment and risk-management needs of individuals, families and nonprofits.

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