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Measuring and beating your benchmark

Oct 16 2015 16:10
Simon Brown

When investing, one of the things that we always talk about is beating your benchmark. 

Typically, that benchmark would be a JSE index such as the Top 40. I always suggest a JSE index as the benchmark as one can buy them if we continue to underperform our benchmark. In other words, if the market is doing better than we are, we should stop trying and simply buy the market, and we would do that via an exchange-traded fund (ETF).

But there are other ways we can measure a benchmark and, importantly, they don’t all have to be relative, they can be absolute. A relative benchmark means that we track ourselves relative to something such as a JSE index.

Importantly, if that index records a negative return for a period and we record a negative return that is less negative (in other words, index is down 10% but our portfolio is only down 5%) then we would consider that still succeeding.

An absolute benchmark means that one always wants a positive return from a portfolio over the time frame, so no negative periods.

I always use a relative benchmark, but an absolute benchmark can be very useful in the right situation.

Relative is a higher risk and hence reward process. The risk is that there will be negative years, but the reward is that the positive years should more than compensate for those negative years of return.

An absolute benchmark would always look for a positive return regardless of what the market is doing. Here, the risk is lower as ideally there would be no negative years, but the reward would also be lower because by reducing risk on the downside, we’d be in lower-risk products that won’t do as well in the booming positive years.

Products included in an absolute portfolio would be cash instruments, debt such as government bonds and preference shares (available via ETFs, while preference shares can be bought directly or via the Grindrod ETF) listed on the JSE.

This portfolio would also include property and potentially a limited amount of shares, but the bulk would be cash (money market) and debt.

This lower-risk absolute benchmark would be more suitable for an investor already in retirement and trying to preserve capital and also those wanting to extract income from the portfolio.

In part, this income would consist of dividends and interest paid, but could also include money derived from the limited selling of the shares.

One could use a number of options as an absolute benchmark that is not based on a JSE index. Two examples would be CPI plus 5% or CPI plus GDP plus 3%. Such a benchmark could consist of pretty much any combination, but note that inflation (in the form of CPI) is generally always included, as growing a portfolio ahead of inflation is critical, otherwise the spending power is being reduced.

Even with this absolute benchmark we could buy it via ETFs, but the risk is that we get the ratios between the different ETFs wrong and this could skew the benchmark.

Another issue using inflation is that often when markets are under pressure, we’d expect to see inflation higher. So achieving that benchmark is going to be tough, although higher rates will benefit a cash/debt portion of the portfolio.

The big question that we should be asking first is what we are trying to achieve. Is it market-beating performance that aims to grow a portfolio over time, but accepting volatility along the way? Or is it about producing income from a portfolio that we can then live off?

This article originally appeared in the 16 April 2015 edition of finweek. Buy and download the magazine here


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