Understanding Benchmarks - Concepts · 1/18/2017 · Understanding Benchmarks Concepts Kevin Webb,...
Transcript of Understanding Benchmarks - Concepts · 1/18/2017 · Understanding Benchmarks Concepts Kevin Webb,...
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).
Indexanumericalscaleusedtocomparevariableswithoneanotherorwithsomereferencenumber...canrevealrelativechangesasafunctionoftime.
BenchmarkAstandardbywhichsomethingcanbemeasuredorjudged.Canhelpsetexpectations.
INDICES BENCHMARKS
Benchmark/IndexExamplesBenchmarkdoesnotnecessarilymeananIndex
Noteveryindexservesasabenchmarkandnoteverybenchmarkisanindex.
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.”
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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.
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.
Webb-o-matic SuitabilityBenchmarkVisualizationAnalysisVerticalbluelinerepresentsbenchmarkforeachmeasure.
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.
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