Thoughts on Investment Benchmarks

Investors in fixed-income securities often use bond indices or other “benchmarks” to determine whether their investment manager is meeting its fiduciary responsibility. The rate of return from interest earnings on the investor’s account plus or minus capital gains or losses is usually compared with the return on an unmanaged market index composed of bonds which are widely traded in the marketplace. This comparison of returns is frequently the yardstick by which the investment manager’s performance for the account is judged. It is essential that to be useful to the investor, as well as fair to the investment manager, the investment benchmark or benchmarks (some investors use more than one) accurately reflect both the investment objectives of the investor and the consequent choice of assets for his/her account.

For bond investors, this is often easier said than done. Investment benchmarks may be misleading in a number of ways. For one thing, they do not incorporate investment transaction costs, which can have a very real impact on portfolio management. For another, bonds in the benchmark index may not reasonably reflect the maturities, credit characteristics, or tax treatment desired by the investor. In such a case, choosing the wrong benchmark is potentially dangerous as well as inaccurate, if it leads to the selection of assets which are not optimally suited to the investor’s objectives and tolerance for investment risk. For example, it would make no sense for an investor seeking conservative, tax-sheltered investments to measure his/her account’s performance against a benchmark index composed of longer-term, medium-grade, corporate bonds. It is equally problematical for an investor in California or Oregon to measure municipal bond performance versus a general market benchmark – even one based on municipal credits – because the benchmark will not be adjusted for the tax benefits of owning in-state credits.

SNW Asset Management’s investment process starts with a rigorous evaluation of each investor’s investment objectives and optimization of the selection of assets. We never manage “to a benchmark” (that would be a case of the tail wagging the dog), instead, SNW Asset Management manages portfolios to each investor’s basic investment objectives, which we go to great lengths to understand beforehand. Because our investment style emphasizes managing through longer-term economic and interest rate cycles – shortening maturities when we believe that interest rates are likely to rise systematically and lengthening maturities when we believe that rates are likely to fall – we usually show investors more than one carefully chosen investment benchmark. These benchmarks often do not and cannot perfectly reflect the investor’s objectives, but even with their imperfections, they should help the investor evaluate whether SNW Asset Management’s choice of investments placed the account in the best maturity sector and whether or not we bought good, competitively-returning assets within our sectors of choice. For the investor, evaluating investment performance is not simply a question of “beating the benchmark,” rather, the benchmark provides a frame of reference for deeper questions as to what assets were chosen and held, why they were chosen, and whether they were efficiently acquired or divested. The best use of investment benchmarks is to promote a sustained two-way dialogue about the investor’s portfolio.