Looking for a Benchmark? Take the obvious one: Client Satisfaction

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Information about Looking for a Benchmark? Take the obvious one: Client Satisfaction
Finance

Published on March 7, 2014

Author: ChristianSchusterCAI

Source: slideshare.net

Description

Anyone who manages client investments is committed to satisfy client’s investment goals. Yet when launching a new investment strategy or implementing a mandate, the question about the benchmark usually revolves around which existing index or combination of indices best represents the investment universe. The discrepancy between the benchmark selected and client satisfaction is often significant. We present a simple benchmark framework based on client satisfaction.

February 2014 Looking for a Benchmark? Take the obvious one: Client Satisfaction Anyone who manages client investments is committed to satisfy client’s investment goals. Yet when launching a new investment strategy or implementing a mandate, the question about the benchmark usually revolves around which existing index or combination of indices best represents the investment universe. The discrepancy between the benchmark selected and client satisfaction is often significant. We present a simple benchmark framework based on client satisfaction. A wealth manager sitting down with a new client or a fund manager before launching a new fund often have a hard time figuring out the appropriate benchmark. Usually, the benchmark chosen represents the closest approximation of the investment universe covered or a combination of indices that the manager is expected to outperform. While both approaches sound reasonable there can be a significant discrepancy between these benchmarks and client satisfaction. Classical scenario Let us take a balanced portfolio approach to demonstrate the discrepancy. The wealth manager suggests the combination of an equity index and a government bond index with weights of 60% and 40%. Rebalancing back to the target weights is done each year (do not neglect the effects of rebalancing). Showing the client how this benchmark would have performed over the last 20 years should clear all doubts. The absolute return achieved is significantly positive, the major equity market drawdowns are smoothed by rising bond prices, and finally the trend for these return and diversification characteristics looks unbroken. At this point the client starts to forecast implicitly because he projects past performance into the future. The major concern at that time might be the skill of the manager to outperform (or even just match) the benchmark and not the benchmark’s future performance. This forecast is dangerous, not only in an environment of rising interest rates. We believe the client cannot assess upfront if he will be satisfied with the manager’s performance against the benchmark. Underperforming a benchmark with an extraordinary high return will usually deliver higher utility to an investor than outperforming a benchmark with negative returns. Also, the lower the risk assumed to achieve these returns, the higher the client satisfaction. ©C.h.r.i.s.t.i.a.n.S.c.h.u.s.t.e.r.Q.A.P.a.r.t.n.e.r.s. A simple framework For a simple framework to measure client satisfaction we make some reasonable assumptions based on common knowledge and behavioral patterns. Higher absolute returns and lower risk are preferred. Risk is not easy to determine. Certainly, time in combination with a risk measure plays a role. We define that an investment strategy which is able to recover losses more quickly dominates another that shows the same magnitude of losses but fails to recover in the same time. The toughest ingredient to anticipate for client satisfaction in the future is the relative performance. Stating in advance that high absolute returns are most important, clients may be partly disappointed by negative relative performance. We could imagine that in countries where equity market participation is high (and you hear people talk about their best stock picks or expect your neighbors to hold the market portfolio) relative performance is more important. Summed up in a chart, we conclude that clients care most about absolute returns and a little bit less about relative returns in the long-term. On a very short time horizon - independent from the manager’s performance clients will not get extremely happy or angry because short-term returns are no guide for the future. On a mid- QA Partners Looking for a Benchmark? Take the obvious one: Client Satisfaction - February 2014 1

term horizon clients are unhappy with negative returns, either absolute or relative ones. They are a bit more optimistic if the manager at least delivers positive relative returns. Chart 1: Client Satisfaction based on absolute and relative returns over three time horizons ©C.h.r.i.s.t.i.a.n.S.c.h.u.s.t.e.r.Q.A.P.a.r.t.n.e.r.s. An example: comparing two equity strategies To make the concept clear with an example, look at two equity strategies. One is a multi-strategy approach on global equities, the second is a passive strategy on the US equity market. You start with the client (or investor target group) to determine the return goals upfront. These goals are stated in satisfaction points. Here, we assume an investor would be 100% (=100 points) satisfied with annual returns of 15%, would be indifferent at 2% and 100% angry when losing 5% annually. Although increasing and decreasing utility for certain areas of return in the calculation would represent a more realistic picture, we assume a linear utility function here. For measuring risk, or better defined as investor’s pain, we use a measure similar to the ulcer index. This measure captures magnitude and length of drawdowns and therefore indicates the pain felt by investors. For a long time horizon we take three years being aware that a far longer time period should be chosen (and shorter periods should be incorporated, too). A relative return measure against an index is neglected for simplification. Return has a weight of 75% and the pain measure contributes 25%. The question why we only weight pain with 25% might come up. In the end, after a long-term investment horizon all that counts for an investor is the absolute return, but the influence of negative emotions felt in the meantime should also be included. Therefore, we only add the satisfaction points from three year absolute returns (rolling) and from the risk figure to arrive at our client satisfaction measure. ©C.h.r.i.s.t.i.a.n.S.c.h.u.s.t.e.r.Q.A.P.a.r.t.n.e.r.s. Starting in 2007 both strategies were on a high satisfaction level thanks to rising stock prices with no major setbacks in the previous three years . Already at the start of 2008 the passive strategy takes a dive that only ends in Mid-2009 on a very low satisfaction level. From Mid-2009 on the passive strategy scales up but it takes until 2012 just to get back into territory where we believe the client’s feeling would be neutral. Looking back from QA Partners Looking for a Benchmark? Take the obvious one: Client Satisfaction - February 2014 2

2014, the passive strategy did not manage to stay on a level of 100% satisfaction for more than a few weeks, although the US equity market exhibited an enormous increase to new highs over the last five years (remember we just included three years into the formula). The pain felt, measured by drawdown severity (e.g. US ratings downgrade in 2011), was a drag on increasing satisfaction. Chart 2: Client satisfaction for two different equity strategies ©C.h.r.i.s.t.i.a.n.S.c.h.u.s.t.e.r.Q.A.P.a.r.t.n.e.r.s. In contrast the multi-strategy global equity approach managed not only to stay in positive satisfaction territory during the complete observation period, it was also above 100% satisfaction the majority of time. Clearly, the multi-strategy approach delivers the higher absolute return and more constant annual return figures but the favorable risk metrics contribute significantly, too. Although you can see drawdowns for that strategy in the chart, these are manageable in a sense that the magnitude of the drawdowns is low and the time to recover is short. Conlusion In its simplest form this benchmark model only requires one return and one risk figure to bridge the gap between the claim to achieve client’s investment goals and measuring client’s satisfaction. We understand that this concept is most applicable for balanced portfolios or broad mandates but it can also be utilized for other strategies. Why not link performance fees to such a client satisfaction benchmark? A performance fee model that shares the same logic, is easily employable, and aligns manager and investor interest can be found in the paper “Better Alignment of Interests through Risk-Adjusted Performance Fees”. Please feel free to discuss or give feedback. Christian Schuster, CAIA cs@qa-partners.com QA Partners Looking for a Benchmark? Take the obvious one: Client Satisfaction - February 2014 3

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