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Investment Reserves – Trust is not an Internal Control

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As the capital markets have become more complex and less transparent, the amount of risk inherent in a portfolio becomes more and more important – and harder and harder to measure.  The need for simple benchmarks that account for the level of risk in a portfolio has never been greater.

Such metrics bring clarity to performance reporting and effectively hold advisors and managers accountable for their results.  The challenge associated with accountability is particularly relevant in an environment where advisors often set the benchmarks against which their performance is measured, and prepare the reports that are used to understand their results. If you didn’t trust your advisors you wouldn’t be working with them.  Trust, however, is not an internal control.
This article, and accompanying worksheet, seeks to provide a framework for understanding and executing a simple, powerful portfolio benchmarking process.

We all understand well the relationship between risk and return.  As an investor or as a fiduciary, we need to know that we’ve been compensated fairly for the level of risk we’ve taken in any particular investment.  It’s important to have relevant context to understand if we’ve been fairly compensated for risk.  Context is made available through the use of benchmarks.

Back in the 1980’s, benchmarking was easy.  Investors typically invested in equity by owning the stock of large US corporations.  An easy, fair, and relevant proxy (or benchmark) for large cap US stocks is the S&P 500 Stock Index.  Investors typically invested in fixed income by owning bonds issued by the US Treasury, Government Agencies, or Large US corporations.  Easy, fair, and relevant proxies were readily available.

Since then, however, markets have evolved.  Not only has investing in traditional markets become more complex but limited partnerships (hedge funds) abound.  These complexities, compounded by a lack of transparency, make risk more difficult to understand and make it harder to identify fair, relevant benchmarks that give context to the results.

It’s helpful if you think about benchmarking from this perspective:  “My Association has decided that that we want 50% of our reserve portfolio to be invested in stocks and 50% in bonds.  We know that we could invest 50% of or portfolio in an S&P 500 stock index fund and 50% in an Aggregate bond index fund.  But, we are willing to hire someone that will give us the expectation that we can generate better returns – after adjusting for any additional risk and additional expenses.”

You should note that a portfolio comprised 50% in an S&P 500 index and 50% in an Aggregate Bond index is commonly referred to as an ‘institutional benchmark portfolio’ or as a ‘non -diversified portfolio’.

There are two ways that an advisor or manager can seek to earn better returns than the institutional benchmark (after both fees and risk are considered):

  1. 1. Asset Allocation
  2. 2. Manager Selection

It is necessary to use at least two benchmarks to identify if value is being added through either endeavor.

Asset Allocation

Through asset allocation, a manager or advisor will diversify beyond US large cap stocks.  A manager or advisor may choose to do any or all of the following:

  1. 1. Include small and mid cap stocks
  2. 2. Emphasize ‘value’ or ‘growth’ orientations.
  3. 3. Diversify internationally and or in emerging market countries
  4. 4. Invest in commodities or inflation adjusted bonds.
  5. 5. Utilize hedge funds, private investments, or other limited partnerships.

Regardless of how your manager or advisor chooses to diversify your portfolio beyond the ‘institutional benchmark’ portfolio, the institutional benchmark portfolio will always hold them accountable for having done so.

It’s important to note that your ‘institutional benchmark’ should consist of the percentage of stocks and bonds that your association has elected.  So, for example, if your Association has elected to have 60% of the portfolio invested in stocks and 40% in bonds your ‘institutional benchmark portfolio’ will be comprised 60% of the S&P 500 stock index and 40% of the BarCap Aggregate bond index.

If you allow your manager to determine the mix of stocks and bonds in your portfolio beyond a relatively narrow ‘rebalancing’ target range than I suggest you identify some static institutional benchmark to use as a guide to give context to their results.

Manager Selection

Whereas the ‘institutional benchmark’ will gauge the degree to which your asset allocation has added value, it’s not terribly helpful in indentifying if the individual managers or mutual funds selected for your portfolio have added value overall.  For this you’ll need a custom weighted benchmark.

This custom weighted benchmark will reflect your asset allocation and therefore it will more closely represent the risk level of your portfolio.  It will be comprised of the various individual asset class benchmarks that are a part of your asset allocation and each asset class benchmark will be assigned the weight that matches the weight each asset class is represented in your portfolio.  An example of such an asset class benchmark is the Russell 2000 Value index.  The performance of this index reflects the performance of small US company stocks with low fundamental valuations.  Including the returns of this asset class in the portfolio benchmark helps account for the greater risk (and return) expected from such an investment.

In order for this custom weighted benchmark to mirror your asset allocation over time, it will fluctuate as the weight of each asset class fluctuates with the market.  The performance of this custom weighted benchmark represents the performance of your asset allocation.  The difference between the performance of this custom weighted benchmark and your actual results is the value added or subtracted related to the managers or mutual funds selected in your portfolio.  The difference between this custom weighted benchmark and the ‘institutional benchmark’ is the value added or subtracted from your asset allocation.

Single Benchmark Solution

If you’re simply interested in identify value added period – not necessarily distinguishing between value added from asset allocation vs. manager selection, the ideal portfolio benchmark is a globally diversified, static benchmark balanced between stocks and bonds to match your organizations investment policy.
The following chart is an example of a detailed asset class breakdown and corresponding globally diversified portfolio benchmark for a portfolio invested 50% in stocks and 50% in bonds.

The indexes used in this benchmark provide comprehensive exposure to each of the equity asset classes (large/small) and styles (value/growth) around the world and to the entire US fixed income market. The weights are market neutral – meaning with no emphasis to a particular style or size. Use the spreadsheet that accompanies this article to easily benchmark the performance of your association’s reserve.

Benchmarking Alternatives

A simple, relevant way to benchmark alternative investment performance is to benchmark them against the traditional investment that they replaced.  Typically, alternative investments will be a replacement for stocks (Russell 3000), bonds (BarCap Aggregate Bond), or a balanced portfolio (60% stocks, 40% bonds).

There are certainly other issues that need to be considered.  Among them is comparing time weighted or dollar weighted returns and accounting for volatility.  Effective benchmarking practices are the answer and they should be clearly outlined in your organization’s Investment Policy Statement.


Raffa Wealth Management is an independent investment advisor providing nonprofit organizations, high net-worth investors, and qualified retirement plans with a full range of investment consulting services.  We were established to fill the need for transparency, clarity, and vision in the professional management of investment assets.   Visit us at