Benchmark Review

In this article Mark Freeman looks at how Trustees can set effective benchmarks for risk and return on their investment portfolios.


Before any changes are made to benchmark and asset allocation, the required level of return and risk appetite should be reviewed, discussed and agreed reviewed with Trustees.

The organisation should consider including in the annual performance reporting a report on the level of risk in the portfolio relative to the marketplace - this will inform the degree of additional risk it has taken on to achieve the levels of return it requires.


Performance measurement should not be reduced to the evaluation of fund returns alone, but must also allow for the measure of risk taken. For some organisations the measure of risk is either ignored or implied by both type of benchmark chosen.

Other aspects are also part of the performance measurement:

   evaluating if the investment manager has succeeded in reaching the objective, i.e. if their return was
      sufficiently high to reward the risk taken

   comparing their performance with their peers

   assessing whether the portfolio management results were due to luck, the manager's skill or other influences

Portfolio benchmarks variance is obtained by measuring the difference between the return of the portfolio and that of a benchmark portfolio. This measure appears to be the only reliable performance measure to evaluate active management in the short term.

Risk and Asset Allocation

When structuring the arrangements with an Investment Manager the starting point should always be to define clearly the required real return needed by an organisation along with any restrictions related to the funds.

Real return is defined as the performance above inflation to ensure that the funds do not diminish in value over time. In setting this requirement the organisation should consider its appetite for risk. The greater the requirement for real return, the greater the risk, and the higher the level of volatility in the performance of the portfolio.

Volatility refers to the degree of (typically short-term) unpredictable change over time of a certain variable. Therefore, the greater the risk the higher the volatility. Higher volatility results in greater swings in performance over shorter periods of time. The level of volatility can be determined by looking at the historical volatility of the market as a whole over varying lengths of time.

Historically, total returns have been around 6.5% with inflation operating at 3.0% to 3.5%, giving real returns in the range 3% to 3.5%. The result of setting a real return of 6% to 7% per annum means that the organisation is willing to accept a level of risk 20 times greater than normally accepted in the market. As a result greater swings (both positive and negetive relative to the marketplace) should be expected over the short term.

Risk level is important as it drives asset allocation, which in turn, enables the organisation to achieve the required return level. Selection of asset allocation ranges is based on those asset classes that will provide the required combined return - those with low levels of annual return are unlikely to form part of the portfolio (e.g. cash or similar asset classes) and those carrying a greater risk will start to form the majority of the portfolio (e.g. equities).

The asset allocation range is there to manage the risk to an organisation in relation to the overall risk it is prepared to tolerate within the portfolio. This range defines and restricts the parameters within which your Investment Manager is allowed to operate. (Without this he/she could take very long or short positions and thus increase exposure to unacceptable risk).

In normal market conditions, it is reasonable to expect an Investment Manager to inform Trustees if they were unable to achieve the agreed return, as well as advising about any adjustments needed to the allocation range to achieve the return required.

As mentioned above there is normally no indication of risk within the reporting. It is very worthwhile to have such a measure of risk relative to the market within the quarterly or annual reporting. In this way, Trustees can and should evaluate the level of risk in the portfolio and compare it to their appetite for risk.

Earlier we mentioned that an organisation should expect returns to under and out perform relative to the market place. To manage and understand this performance benchmarks are used to gauge the quarter-to-quarter performance of the Investment Manager.

Benchmarks do not represent the risk in the portfolio but represent the performance of that class of asset. The overall performance should mirror the short term performance required to achieve the longer term return that the Trust requires.

Of course, in any one year an organisation is unlikely to achieve its stated requirement of 6% to 7% real return but over a period of three to five years, and in current market conditions potentially longer, this could be the expected return. This is the ultimate measure of the Investment Manager over time.

As it is not possible to assess short term performance (e.g. quarterly/annually) the use of indices, benchmarks and their blended performance are used. When short performance is being evaluated the level of risk should be assessed relative to what has been agreed with the Investment Manager to deliver over the long term.

The higher the level of risk the more often the performance will be out of alignment with the indices benchmark.

The lowest possible risk relative to an indices benchmark is a tracker fund which will return the long term expected historical return of 6.5% (or real return of 3.0% to 3.5%) as well as matching the indices each quarter.


We can see that benchmarks and asset allocation for any organisation are based on a level of return required by the organisation over time, and the level of risk that Trustees feels is appropriate.

If the level of risk is too high then the real returns will have to be reduced. Once the level of real return and the risk have been agreed and accepted then the asset allocation can take place. This may result in a further refinement of the risk appetite and required returns.

Finally once all these factors have been refined and agreed, benchmarks appropriate to measure short term performance can be agreed with your Investment Manager.


The starting point for any charitable organisation undertaking a benchmark review is to first review the level of real return required and the resulting risk from this. Provided the organisation accepts the level of risk, then the asset allocation can proceed along with assessing the most appropriate benchmarks to assess short term performance.

Mark Freeman CA (Canada) MIFS