Using Benchmarks to Assess Portfolio Risk and Return

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Type: 
Best Practice
Background: 

Measuring portfolio risk and return results against appropriate market benchmarks1 is a technique to verify that all the investment objectives are being met and that portfolio investment returns are appropriate for the risk incurred.  Comparing total return to a proper benchmark or index is the preferred means for assessing performance relative to risk and investment objectives.

Investment yield alone is not sufficient for assessing risk and performance.  Investment yield measures the percentage increase or decrease that a portfolio generates during a given period and is useful for budgeting purposes but overall, is unreliable for decision making and assessing the risk and return characteristics of the portfolio.

  1. There are many definitions of yield such as:  yield to maturity, yield to call, book yield, and market yield.  
  2. Yield results can be distorted by the timing of investing relative to the current level of interest rates and by the presence of call options. For example, it is possible to sell a bond at a loss and buy another bond with a higher yield leaving an increase in the investment portfolio yield but a decrease in the portfolio size.  
  3. Yield can be manipulated to generate more income or show higher yield in one particular period as opposed to others.
Recommendation: 

The Government Finance Officers Association recommends that government investors assess their investment portfolio for performance and risk by comparing the total return of the portfolio to carefully selected benchmarks.  Total return provides a complete snapshot of the outcomes resulting from investment decisions since it measures the percent change in the value of a portfolio over a defined historical period.

  1. Total return comparisons should be completed as least quarterly and more often for portfolios managed by external provides and those containing large investments.

Any total return measurement that is much greater or much less than that of the benchmark should be analyzed since significant deviations between the total return measurement and the benchmark often correlates to the portfolio risk profile.  Based on total return analysis, investment managers can make adjustments to the portfolio's risk profile when it is determined to be outside the acceptable variance with the benchmark.

To provide a valid reference for comparison of an entity’s investment portfolio, it is important to select a benchmark that closely resembles policy constraints and management practice in terms of duration, maturity range, average duration, security types, sector allocations and credit quality.  
Selected benchmark should:

  1. Be unambiguous and transparent – The names and weights of securities that constitute a benchmark should be clearly defined;
  2. Be investable – The benchmark should contain securities that an investor can purchase in the market or easily replicate;
  3. Be priced on a regular basis – The benchmark’s return should be calculated regularly;
  4. Be supported by historical data – Past returns of the benchmark should be available in order to gauge historical returns;
  5. Be specified in advance – The benchmark should be adopted prior to the start of evaluation;
  6. Be consistent – Consistently keep the same bench mark for comparison purposes;
  7. Have published risk characteristics – The benchmark provider should regularly publish detailed risk metrics of the benchmark so an investor can compare his/her portfolio risks against the benchmark risks; and
  8. Have a composition that is similar to the portfolio holdings.
Committee: 
Treasury and Investment Management
Notes: 

1  A benchmark (or index) is an unmanaged basket of securities that provides a reference for understanding performance and risk characteristics of an investment strategy given investment policy parameters.

Approved by GFOA's Executive Board: 
January 2015