UnderstandingBenchmarksConcepts

KevinWebb,CFAkwebb@cantor.comCantorFitzgerald,LLP

UnderstandingBenchmarks- ConceptsAgenda

Benchmark/IndexExamples

WhatShouldIBenchmark?

HowShouldIBenchmark?

ChocolateCoin/SpreadsheetWorkshop

Assumptions/Definitions

RiskDefinedMorethingscanhappenthanwillhappen.

Zweig,Jason.TheDevil'sFinancialDictionary(p.182).PublicAffairs.KindleEdition.Emphasisadded.

… IthasbeenphilosophicallydefinedbyfinanceprofessorElroyDimsonofLondonBusinessSchoolthisway:“Riskmeansmorethingscanhappenthanwillhappen.”Intheend,riskisthegapbetweenwhatinvestorsthinktheyknowandwhattheyenduplearning— abouttheirinvestments,aboutthefinancialmarkets,andaboutthemselves.

*ThescientistwhodevelopedtheSaturn5rocketthatlaunchedthefirstApollomissiontothemoonputitthisway:"Youwantavalvethatdoesn'tleakandyoutryeverythingpossibletodevelopone.Buttherealworldprovidesyouwithaleakyvalve.Youhavetodeterminehowmuchleakingyoucantolerate."(ObituaryofArthurRudolph,inTheNewYorkTimes,January3,1996.)

Risk&ReturnareRelatedFindingtherighttrade-offisthekey

PeterL.Bernstein.AgainsttheGods:TheRemarkableStoryofRisk(KindleLocations69-71).KindleEdition.Emphasisadded.

Brandreth,Gyles.OxfordDictionaryofHumorousQuotations(KindleLocation4265).OUPOxford.KindleEdition.SeethisusefulMicrosoftHelppageforMicrosoftWordonthedefinition/historyof“LoremIpsumDolorSitAmet Etiam”:

https://support.microsoft.com/en-us/kb/114222

Definitions

“Knowledgeisknowingatomatoisafruit;Wisdomisnotputtingitinafruitsalad.”

Benchmark

WolframAlpha,http://www.wolframalpha.com/input/?i=benchmark&rawformassumption=%7B%22C%22,+%22benchmark%22%7D+-%3E+%7B%22Word%22%7D&rawformassumption=%7B%22DPClash%22,+%22FinancialE%22,+%22benchmark%22%7D+-

%3E+%7B%22NYSE:BHE%22%7D (December30,2016).

Benchmarks~Expectations

Index

WolframAlpha,http://www.wolframalpha.com/input/?i=index(December30,2016).

Indexanumericalscaleusedtocomparevariableswithoneanotherorwithsomereferencenumber...canrevealrelativechangesasafunctionoftime.

BenchmarkAstandardbywhichsomethingcanbemeasuredorjudged.Canhelpsetexpectations.

INDICES BENCHMARKS

Benchmark/IndexExamplesBenchmarkdoesnotnecessarilymeananIndex

Noteveryindexservesasabenchmarkandnoteverybenchmarkisanindex.

BenchmarkingFedFunds?

PureBenchmarkExample– TheTaylorRule

CenterforQuantitativeEconomicResearch,FederalReserveBankofAtlanta,https://www.frbatlanta.org/cqer/research/taylor-rule.aspx (Dec31,2016).*Seehttp://www.investopedia.com/video/play/taylor-rule-calculating-monetary-policy/ forashortvideoexplainingTheTaylorRuleand

furtherdetailsontheequation.

“TheTaylorruleisanequationJohnTaylorintroducedina 1993paper thatprescribesavalueforthefederalfundsrate—theshort-terminterestratetargetedbytheFederalOpenMarketCommittee(FOMC)—basedonthevaluesofinflationandeconomicslacksuchastheoutputgaporunemploymentgap.”

-2

0

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4

6

8

10

2000 2002 2004 2006 2008 2010 2012 2014 2016

EffectivefederalfundsrateandTaylorruleprescriptionPercent

TaylorruleprescriptionActualFedFundsRate i = r* + pi + 0.5 (pi-pi*) = 0.5 (y-y*):

Wherei isthenominalfederalfundsrate,rasteriskistherealfederalfundsrate,piistherateofinflation,pasteriskisthetargetinflationrate,yisalogarithmofrealoutput,andyasteriskisalogarithmofpotentialoutput.*

PureIndexExample– ChristmasPriceIndex

ThePNCChristmasPriceindex,https://www.pnc.com/en/about-pnc/topics/pnc-christmas-price-index.html (Dec31,2016).

ThePNCChristmasPriceIndex® showsthecurrentcostforonesetofeachofthegiftsgiveninthesong"TheTwelveDaysofChristmas."

IndexasBenchmarkExample– BigMacIndex

Interactivecurrency-comparisontool:TheBigMacindex,TheEconomist,http://www.economist.com/content/big-mac-index (July21,2016).

TheBigMacindexwasinventedbyTheEconomistin1986asalightheartedguidetowhethercurrenciesareattheir“correct”level.Itisbasedonthetheoryofpurchasing-powerparity(PPP)...Forexample,theaveragepriceofaBigMacinAmericainJuly2016was$5.04;inChinaitwasonly$2.79atmarketexchangerates.Sothe"raw"BigMacindexsaysthattheyuanwasundervaluedby45%atthattime.

WhatShouldIBenchmark?

CaliforniaStateCode53600-53610WordCloud

GFOASampleIPSWordCloud

PrudencePersonStandard“Investmentsshallbemadewithjudgmentandcare,undercircumstancesthenprevailing,whichpersonsofprudence,discretionandintelligenceexerciseinthemanagementoftheirownaffairs,notforspeculation,butforinvestment,consideringtheprobablesafetyoftheircapitalaswellas

theprobableincometobederived.”

GFOASampleInvestmentPolicy,accessed12/31/16,page2.Emphasisadded.

GeneralObjectives“Theprimaryobjectives,inpriorityorder...1.SafetySafetyofprincipalistheforemostobjective…Thegoalwillbetomitigatecreditriskandinterestraterisk.2.LiquidityTheinvestmentportfolioshallremainsufficientlyliquid tomeetalloperatingrequirementsthatmaybereasonablyanticipated.3.ReturnTheinvestmentportfolioshallbedesignedwiththeobjectiveofattainingamarketrateofreturnthroughoutbudgetaryandeconomiccycles,takingintoaccounttheinvestmentriskconstraintsofsafetyandliquidityneeds.”

GFOASampleInvestmentPolicy,accessed12/31/16,pages1-2.Emphasisadded.

WhatMeasurestoBenchmark?The5PointsofSuitability

IndexFindanIndexthatisclosesttoyourrisk/rewardpreferencesandthenuseitasaproxyfortherisk/rewardmeasuresyouwanttobenchmark.

BenchmarkDetermineyourpreferencesforeachrisk/rewardmeasureandusethoseasabenchmark.

INDICES BENCHMARKS

HowShouldIBenchmark?UseanIndexorBenchmarkIndividualRisk/RewardMeasures?

Markets:Equities=Indices/Bonds=Yields?

TheFinancialTimes,MarketsData,http://markets.ft.com/data/ (January7,2017).

BondMarketIndicesOverview

AGuidetotheLehmanBrothersGlobalFamilyofIndices– GlobalFamilyofIndices35th Anniversary1973-2008,page8,March2008.Note:BarclayspurchasedLehmanBrothersassets(includingtheindices)afterLehman’sbankruptcyinSep-08.Barclay’scurrentguide

canbefoundhere:https://index.barcap.com/Home/Guides_and_Factsheets

BondMarketIndicesareRuleBased

AGuidetotheLehmanBrothersGlobalFamilyofIndices– GlobalFamilyofIndices35th Anniversary1973-2008,page11,March2008.

1-5YrBondMarketIndicesOverviewasof12/31/16

BankofAmerica-MerrillLynchIndexDataasof12/31/16.http://www.mlindex.ml.com/gispublic/bin/MLIndex.asp

Fixed-incomebenchmarksembodyagreatmanycomplexissues…twoissues:thedurationproblemandthe“bums”problem.…Thedurationproblemisthefactthatthedurationofthebenchmarkcomesfromissuerpreferencesandisnotnecessarilythedurationthatagiveninvestorshouldhold.Thebums(ordeadbeats)problemisthatthebiggestdebtors(whethercompanies,countries,orotherentities)havethelargestweightsinthebenchmark.

ProblemsUsingBondIndicesasBenchmarksBums&Duration

InvestmentPerformanceMeasurement:EvaluatingandPresentingResults(CFAInstituteInvestmentPerspectives)(KindleLocations4006-4012).Wiley.KindleEdition.

Thedurationstructureofacap-weightedbondbenchmark—thatis,theproportionsofbondsinshort-,intermediate-,andlong-termcategories—reflectsthematurityordurationpreferencesofissuers,whoareseekingtominimizetheir(apparent)costofcapital.Investors,however,arenottryingtominimizetheirreturns(whicharetheissuers’costsofcapital)buttomaximizereturns.Moreover,aninvestorusuallyhasspecifictime-horizonpreferencesthatmakeonedurationmoreadvantageousthananother.Thesepreferencesdonotnecessarilymatchthoseofissuersintheaggregate,whosepreferencesarereflectedinthebenchmark....Becausethebenchmarkdurationisahistoricalaccident,theoptimalportfolioforaninvestorwithnodefinedtimehorizonshouldbesetbythatinvestor’srisktoleranceratherthanbymatchingthedurationofthebenchmark.

TheDurationProblem

InvestmentPerformanceMeasurement:EvaluatingandPresentingResults(CFAInstituteInvestmentPerspectives)(KindleLocations4067-4082).Wiley.KindleEdition.Emphasisadded.

Becausetheissuerswhomanagetogodeepestintodebt—thebiggestbums—havethelargestweightsinacap-weightedbenchmark,suchabenchmarkisnotlikelytobemean-varianceefficient.Ifyouaretrackingsuchabenchmark,whensomeoneissuesasecurity,youhavetobuyitinproportiontoitscapitalizationweighttominimizetrackingerrortothebenchmark,evenifthesecurityisonlymarginallyofhighenoughqualitytomakeitintothebenchmarkandevenifthesizeoftheissue,andhenceitsweightinthebenchmark,isinordinatelylarge.Suchsecuritieswouldseemtobethemostlikelytobedowngradedortodefault.ThebumsproblemappliestocountriesinaninternationalsovereignbondbenchmarkjustasitdoestocorporationsinaU.S.bondbenchmark.

The“bums”Problem

InvestmentPerformanceMeasurement:EvaluatingandPresentingResults(CFAInstituteInvestmentPerspectives)(KindleLocations4102-4107).Wiley.KindleEdition.Emphasisadded.

SuitabilityBenchmarkProcessYoudecideyourbenchmarks.Don‘tletanindexdecide.

1.LiquidityExaminehistoricalcashflowstodetermineoptimalliquidity.

2.InterestRateRiskUseTreasuryBellwethers

togeta“feel”foryourinterestraterisk

preference.

3.CreditRiskUsecreditanalysistodeterminepreference

forcreditvolatility.

4.MarketRateofReturnUseindicesorliabilitiestodetermineoptimalmarketrateofreturnbenchmarkpoint/range.

VisualizingthePortfolioversustheBenchmarksGoodvisualizationsbringtogetheracomplexnarrative…

VisualizingthePortfolioversustheBenchmarks…andallowrelativecomparisonsacrossdifferentmeasures.

Webb-o-matic SuitabilityBenchmarkVisualizationAnalysisVerticalbluelinerepresentsbenchmarkforeachmeasure.

ANoteonTotalReturn/MarketRateofReturn

WhatareyourReturnPreferences?TotalReturnassumesindifferencebetweenPricereturn&Incomereturn.

PriceIncome

ManagingInvestmentPortfolios:ADynamicProcess(CFAInstituteInvestmentSeries)(p.723).Wiley.KindleEdition.Emphasis added.

Totalrateofreturnmeasurestheincreaseintheinvestor’swealthduetobothinvestmentincome(forexample,dividendsandinterest)andcapitalgains(bothrealizedandunrealized).Thetotalrateofreturnimpliesthatadollarofwealthisequallymeaningfultotheinvestorwhetherthatwealthisgeneratedbythesecureincomefroma90-dayTreasurybillorbytheunrealizedappreciationinthepriceofashareofcommonstock.

IncomeMostpublicfundsare

incomeorientedandputmoreweightonincome.

Ifyoudon’tbudgetgains/lossesandaren’ttaskedwithportfolio

growthfrominvestmentsthenyoulikelyhavean

incomepreference.

TheGIPSstandardsaretypicallyusedwhenperformanceinformationiscommunicatedbetweenaninvestmentfirmandprospectiveinstitutionalinvestors...thereisnolawthataninvestmentfirmmustcreateitsmarketingmaterialsaccordingtotheGIPSstandards...

WhataboutGIPS?TheGlobalInvestmentPerformanceStandards

Feibel,BruceJ.;Vincent,Karyn D..ComplyingwiththeGlobalInvestmentPerformanceStandards(GIPS)(FrankJ.Fabozzi Series)(KindleLocations321-326).Wiley.KindleEdition.

ThefirstthingIgetaskedabouttheportfoliois…

GeneralObjectives“Theprimaryobjectives,inpriorityorder...1.SafetySafetyofprincipalistheforemostobjective…Thegoalwillbetomitigatecreditriskandinterestraterisk.2.LiquidityTheinvestmentportfolioshallremainsufficientlyliquid tomeetalloperatingrequirementsthatmaybereasonablyanticipated.3.ReturnTheinvestmentportfolioshallbedesignedwiththeobjectiveofattainingamarketrateofreturnthroughoutbudgetaryandeconomiccycles,takingintoaccounttheinvestmentriskconstraintsofsafetyandliquidityneeds.”

GFOASampleInvestmentPolicy,accessed12/31/16,pages1-2.Emphasisadded.

Returnislastforprimaryobjectivesbutusuallythefirstquestionasked…

GFOASampleIPS

"...thebasicassumptionthatmostinstitutionalinvestorscanoutperformthemarketisfalse.Theinstitutionsarethemarket.Theycannot,asagroup,outperformthemselves.Infact,giventhecostofactivemanagement—fees,commissions,andsoforth—mostinvestmentmanagerswill,overthelongterm,underperformtheoverallmarket....

Foranyonemanagertooutperformtheotherprofessionals,hemustbesoskillfulandsoquickthathecanregularlycatchotherprofessionalsmakingerrors—andcansystematicallyexploitthoseerrorsfasterthanotherprofessionalscan....

Thebeginningofwisdomforyouistounderstandthatfew—ifany—majorinvestmentorganizationswilloutperformthemarketaveragesoverlongperiodsoftimeandthatitisverydifficulttoestimatewhichmanagerswilloutperform....

Thetrulyimportantbutnotverydifficulttasktowhichinvestmentmanagersandtheirclientscouldandshoulddevotethemselvesinvolvesfoursteps:(1)understandingtheclient’srealneeds,(2)definingrealisticinvestmentobjectivesthatcanmeetaclient’srealisticneeds,(3)establishingtherightassetmixforeachparticularportfolio,and(4)developingwell-reasoned,sensibleinvestmentpoliciesdesignedtoachievetheclient’srealisticandspecifiedlong-terminvestmentobjectives.Inthiswork,successcanbeeasilyachieved."

Ellis,CharlesD..WinningtheLoser'sGame:TimelessStrategiesforSuccessfulInvesting(WinningtheLoser'sGame,3rded)(KindleLocations243-540).McGraw-HillEducation.KindleEdition.

KevinWebb,CFADirector

CantorFitzgeraldkwebb@cantor.comwww.cantor.com

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