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| First Person: Industry View |
The Measure of Success
Glenn G. Kautt
07/01/2005
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Glenn G. Kautt is president of the Monitor Group in McLean, Va., which provides
comprehensive wealth management services for 190 families. In the financial
consulting and planning business since 1981, he received his MBA from Harvard
Business School and is a President’s Distinguished Scholar graduate of Purdue
University. He authored Stochastic Modeling: The New Way to Predict Your
Financial Future and is now writing a book aimed at business owners
transitioning out of their firms.
Throughout the ages, people have used measurement to understand, control,
manage and enhance the performance and efficiency of systems, businesses,
processes and life itself. In finance, the pressing question is what, if any,
benchmarks might serve as appropriate measurements for portfolio
performance.
 From a practical standpoint, a number of things, such as
liquidity, return or risk, are important to investors. While there are ways to
measure these items, each provides only a portion of the information investors
need and does not give the all-inclusive benchmark they seek. For example, in
the highly competitive world of professional sports, coaches benchmark players’
performance by comparing them with other players. However, if you are the team’s
owner, what you really care about is overall performance: Did your team
win?
As an investor, gathering certain data is going to tell you about
relative investment efficiency, but what you really want to benchmark is total
risk-adjusted performance. Is it possible to use an appropriate benchmark to
measure relative investment efficiency, and then to somehow consolidate
individual measurements to gauge total risk-adjusted performance?
First you
would have to find the appropriate index. The most widely quoted benchmark is
the S&P 500 Index. However, the U.S. market is estimated to contain more
than 15,000 stocks. Though the S&P 500 Index represents about 78 percent of
the domestic market capitalization, it does not represent the behavior or
performance of the remaining 14,500 companies. Besides the S&P 500 Index,
there are about 35 foreign market indices, more than a dozen U.S. public indices
covering different portions of the equity and bond markets and numerous
proprietary indices. So, is it reasonable to measure your portfolio against the
S&P 500 Index, the Wilshire 5000 Index or some other index?
No, for
several reasons.
First is risk. Having a basic understanding of
risk-adjusted portfolio performance measurement tools is critical. Knowing how
the measurement tools work helps you understand what adjustments must be made to
the benchmarks. Prudent investors seek both higher-than-average returns and
lower-than-average risk. In the past few years, sophisticated managers have
started using tools ranging from ratio analysis to stochastic computer models to
adjust return performance for the impact of risk.
The second reason for not
using a simple index is fit. If your portfolio looks like the underlying
securities in one index, you do not have enough diversification to overcome
nonsystemic risk (that is, risk that arises from your specific investments
rather than the overall direction of the market itself). If your portfolio is
diversified enough to reduce or eliminate nonsystemic risk, you may think you
can benchmark performance using multiple indices. In theory, it sounds like a
great idea, but the practical application is problematic. These indices just do
not exist. There are no indices for an individual stock, bond, option, future,
specialty fund, real estate or any subset of specific investments in your
portfolio. Using any individual index as a benchmark for a properly diversified
portfolio will give you little practical information on total risk-adjusted
performance or investment efficiency.
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