Chandler Bond Market Review

5 Reasons Why Total Return Benchmarks Are Effective Tools for Measuring and Managing Investment Risk

This article examines five reasons why total return benchmarks are effective tools for measuring and managing investment risk. The purpose of this article is not to argue the merits of total return over other measures. Performance measurement is not an “either/or” choice. Both yield and total return evaluations are important for managing portfolios. Yield calculations provide estimates for the earnings from the portfolio; such information is valuable for budgeting and forecasting. At the same time, total return measures provide important information on the effectiveness in managing the risk in a portfolio.

1. Requires Consideration of the Proper Risk Profile
The first step in selecting an appropriate benchmark is determining the proper risk profile for an entity’s portfolio. This is based on investment constraints, investment objectives, and the risk tolerances of the entity. There are fixed income benchmarks available for just about any risk profile an investor might select as appropriate. A benchmark is a composite of securities that meet certain criteria, such as duration or maturity, credit quality, and asset class for example. Effective benchmarks are:

  • Unambiguous and transparent – the names and weights of securities in the benchmark are clearly defined
  • Investable – an investor can purchase the securities in the benchmark
  • Measurable – the benchmark’s return is calculated regularly
  • Appropriate – the selected benchmark should be consistent with the style being gauged
  • Reflective of current investment opinions – all market participants must be able to have current knowledge of the benchmark
  • Specified in advance – the benchmark is constructed prior to the start of evaluation

The lengthy historical performance data for benchmarks provides investors valuable information on how different risk profiles perform in various interest rate scenarios. The mere process of selecting a benchmark based on the proper risk profile for a portfolio provides an investor the critical, but often missed, opportunity to examine carefully the level of risk and degree of diversification that is most appropriate for the investor.

2. Creates Disciplined Investment Process
Benchmarks are not only used for measuring and evaluating the performance of a portfolio, but also for making investment decisions, such as the mix of securities that will create the targeted risk profile in the portfolio. The benchmark an investor selects helps create discipline in the investment process by establishing a framework for choosing securities that have the proper type and level of risk for the portfolio. For that reason, once selected, benchmarks should only be changed when an investor’s constraints, objectives, or risk tolerances change. They should not be changed solely because market conditions change or because the portfolio is being managed to different risks characteristics than the benchmark.Benchmarks create discipline by:

  • Providing guidance for investment decisions and security selection
  • Keeping an investor focused on maintaining the targeted risk profile
  • Controlling exposure to interest rate changes in the portfolio by targeting the benchmark’s duration
  • Improving return and earnings expectations in various interest rate environments

3. Measures Effectiveness of Strategies
The effectiveness of an investment program, whether it is achieving its objectives, can be measured by comparing the total return of the portfolio to that of the benchmark. Total return measures total outcomes of investment decisions. It measures the percent change in the value of a portfolio over a defined past period, taking into consideration not only interest earnings, but also realized and unrealized changes in market value that occurred during the measurement period.The goal is not to significantly outperform the benchmark but to achieve a total return comparable to that of an appropriate benchmark with comparable levels of risk. Any returns that are much greater or much less than that of the benchmark should be analyzed.

4. Provides Valuable Information on Fulfilling Fiduciary Duty
Certain investors have special duties for the funds they manage. Investors of public funds, for example, have such a special responsibility for the funds they manage. They are fiduciaries subject to a relationship of trust with the beneficiaries of the funds under their care. They are legally responsible for these funds, and must act prudently and always in the best interest of the beneficiaries.The primary objectives of public sector investment portfolios are safety, liquidity and yield or return. Safety and liquidity always take precedence over the objective of yield or return. The test of a fiduciary is one of conduct. Comparing the risk characteristics and total return of the portfolio to that of the selected benchmark allows finance directors, treasurers and oversight boards to evaluate whether the portfolio’s return is commensurate with the agreed upon targeted risk profile. Total return benchmarks assist in the monitoring of fiduciary duty by:

  • Providing clear strategy communication to board / others
  • Managing expectations of returns (and risk)
  • Performance should be close to the benchmark return
  • Any variance in return will be due to variance in decisions for duration, sector weighting, credit quality, and maturity structure
  • The degree of variance in the portfolio’s return will inform an oversight board on the manner in which the portfolio’s risk is being managed relative to the selected benchmark’s risk

5. Total Return Benchmarks are the Accepted Industry Standard
Total return is the agreed upon industry standard. It is universally accepted by academic literature and best practice. Uniformly applied to all portfolios, it provides full disclosure, transparent and fair representation of investment performance to allow comparison and evaluation. Yield only measures the income that can be expected from a portfolio during a given period. In preparing annual portfolio revenue projections and for budgeting purposes, yield information can be helpful. However, yield does not measure risk in the portfolio and cannot be compared against a benchmark on a risk and return basis. There is no standard definition of yield. Investors can chose between yield to maturity, yield to call, book yield, and market yield. As well, yield results can be distorted by timing decisions. For example, an investor can decide to generate more income and thereby show higher yield in one particular period by selling securities that show gains. Because of the potential for variability in yield, it provides limited information and no assessment of the risk in a portfolio and how the investor’s decisions are working out.

Only by using total return measures compared to an appropriate total return benchmark can an investor gauge the success or failure of his portfolio decisions.

RISKS AND OTHER IMPORTANT CONSIDERATIONS

This report is provided for general information purposes only and should not be construed as specific legal, tax, or financial planning advice. All opinions and views constitute judgments or relevant information as of the date of writing and such information may become outdated or superseded at any time without notice. This report is not intended to constitute an offer, solicitation, recommendation or advice regarding any securities or investment strategy. This information should not be regarded by recipients as a substitute for the exercise of their own judgment. Fixed income investments are subject to interest, credit, and market risk. Interest rate risk: the value of fixed income investments will decline as interest rates rise. Credit risk: the possibility that the borrower may not be able to repay interest and principal. Low rated bonds generally have to pay higher interest rates to attract investors willing to take on greater risk. Market risk: the bond market in general could decline due to economic conditions,especially during periods of rising interest rates.

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