An “Aha Moment” Regarding Performance Measurement
by: William Spitz
Performance measurement is an important component of investment management since individual investors have a personal stake in the achievement of their investment goals, and fiduciaries have a legal responsibility to assess the progress of the funds for which they are responsible. But, performance measurement is also fraught with peril. Many investors focus intensely on the performance of the various components of their portfolio versus market benchmarks without considering overall progress towards the goal for which the fund was created. Others make decisions based on inadequate time frames. There is an ever-present urge to “do something” if performance is deemed inadequate. And, the act of doing something is often counterproductive since it is likely to occur at just the wrong time.
I am neither desirous nor capable of writing a treatise on performance measurement but there is one behavioral component of this topic that I find fascinating and would like to address. Having participated in hundreds if not thousands of client meetings, I have noticed a powerful tendency to scan the portfolio performance report and immediately focus on the category that is not performing well, particularly in absolute terms. What is wrong with this practice? First, the offending component often represents a small portion of the portfolio and the ensuing discussion may well detract from consideration of overall portfolio progress. Second, as previously mentioned, there is the issue of time frame and the fact that the poor performance may well be coming on the coattails of a period of extraordinary returns. And, now for the “Aha Moment.”
If a portfolio is properly diversified, there should always be some component that is not performing well. What, am I suggesting that it is good to have poor performers in the portfolio? Well, yes! If one had perfect foresight, this wouldn’t be necessary. But, in reality, no one really knows what will happen in the economy and markets so portfolio construction is all about including assets that should perform well in different environments thereby providing a cushion against those that are underperforming. As just one example, US Treasury Bonds perform very well in a world characterized by low inflation or deflation whereas commodities typically perform poorly. And, the converse is true. So, in a world of high or low inflation, one or the other of these asset classes should not be performing well.
The key message is that one shouldn’t be fazed by low or negative returns in one or more components of the portfolio if they were included for the right reasons. Quite the contrary, one should be concerned if everything is going swimmingly because that is an indication that all of the components of the portfolio are highly correlated and it is therefore under diversified and vulnerable to a market shock of one sort or another. Of course, this is not to suggest that poor performers should be ignored. But, the key is to evaluate why each category was included in the portfolio and whether it is fulfilling its defined role.