Many advisors know what benchmarking is and how to use it. Many advisors think they know what benchmarking is and aren't fully sure how to master it. Which one are you? Do you follow portfolio benchmarking methodology and protocols, like a Samurai warrior, or do you just throw punches? In either case, it is useful to recall the essential attributes of benchmarks taught through the mnemonic Samurai¹:

• Specified in advance: The benchmark is specified prior to the evaluation period.
• Appropriate: It is consistent with the manager’s investment style or area of expertise.
• Measurable: The return is readily calculable on a reasonably frequent basis.
• Unambiguous: Identities and weights of securities are clearly defined.
• Reflective of current investment opinions: The manager has current knowledge of the securities in the benchmark.
• Accountable: The manager should be aware and accept accountability for the constituents and performance of the benchmark.
• Investable: It is possible to simply hold the benchmark.

These attributes can be gleaned and analyzed with the wealth of knowledge available, and powerful tools to bring them into practice. Mastering benchmarks has two benefits: You can make informed decision when selecting investments, and you improve communication with your clients through better accountability and expectations. As you review last year’s performance and prepare for the new, now is a perfect time to educate yourself and your clients about appropriate benchmarks for their investments.

Market indices are readily available and fulfill most of the desirable attributes for benchmarks, however it is still your duty to understand the indices and ensure that the index selection is appropriate.

To start with, make your client aware of the most common market indices and how they relate to their investments. Note that the ubiquitous S&P 500 index, representative of U.S. large-cap stocks, is only a portion of the investable equity market. U.S. small-cap stocks, international developed markets and the U.S. corporate bond markets can be tracked by the Russell 2000 index, the MSCI EAFE index and the Barclays US Aggregate index, respectively. The above are just examples of popular indices; you should visit these providers websites to consult the definition of the indices, how they are constructed, and what other indices are available. Also, make sure to use indices reporting total return (including dividends and capital gains) in order to accurately reflect performance.

After you show your clients how each asset class can be associated with an index, there are further steps you can take to present performance in a fair, realistic manner.

Point out volatility. If you look only at the benchmark returns, you are missing crucial information. Markets regularly experience clusters of high volatility affecting each asset class in different ways. During these episodes, balanced portfolios with diversification in multiple asset classes fulfill their mission of better stability. When comparing asset classes or analyzing a balanced portfolio, contrast the losses occurring for each index during these adverse episodes, possibly with a maximum draw visual or a volatility chart.

Use a “blended” benchmark. There is no readily available index that can be used to benchmark a portfolio because each portfolio has a specific mix of asset classes. However, you can compose a blended benchmark with the indexes, using the asset class weights as defined in the client’s policy statement. Easy-to-use tools exist to quickly assemble blended benchmarks. Beyond client communication, blended benchmarks are useful as a management tool: You can use them in assessing performance of a fund that is hard to classify in any style because it holds investments across asset classes.

Prepare your benchmarks. This part demonstrates the most important buy-in, which is the measurable component of Samurai. Once your client is familiar with benchmarks, educate him on why they are useful not only for past performance analysis, but for future planning purposes. In agreement with your client, this specification in the policy statement sets the right expectations and ensures a fair review at the end of the year.

In conclusion, benchmark methodologies, Samurai or otherwise, are important for portfolio performance review, forward planning, and your selection of investments. Benchmarks, albeit dynamic and interactive, act as a reference and a key component to educating and communicating with clients.

 ¹ Managing investment portfolios: A dynamic process, Maginn, Tuttle, Pinto, McLeavey.

Christophe Gauthron, CFA is the Founder of Kwanti, a software provider to financial advisors and institutions.