Investment benchmarking

inSight

15 Jun 2006

Investment benchmarking

Benchmarking is a useful discipline, both for personal wealth management and the management of the Exchange Fund.

The concept of benchmarking in investment management is a well established one. Designing an investment benchmark is all about balancing the risks that the investor can afford to take, the liquidity he requires and the long-term investment return he hopes to achieve. Everybody wants a higher rate of return on his money, but realistically this cannot be achieved without taking greater risks or sacrificing liquidity, or both. Having an investment portfolio that promises a very high rate of return is no use if you cannot sell all or part of it when you need the money. It may also be of concern to the investor if the short-term rate of return is very volatile, causing substantial losses occasionally, even though the average annual rate of return may be positive and high in the long run.

It is not unusual for investors to put their money into investment vehicles that promise high rates of return, only to find out later that the risks involved are well beyond their appetite or there is no market for the instrument when they want to sell out. Investors, big or small, must therefore pay attention to the risks and liquidity associated with prospective investments, as well as the expected rate of return. They should try to do this as a matter of habit when making individual investments. If they hold a portfolio of investments, they should frequently assess the risk, liquidity and return profile of their investments as a whole, and see whether they are satisfied with the balance among the three factors. Chances are they may already be quite happy about the balance, which means they have got their investment benchmark roughly right. Otherwise, it may not be a bad idea to adjust or even design their own benchmark portfolio.

Designing a benchmark portfolio can be very technical. There are many highly sophisticated mathematical models developed for this purpose. The HKMA uses some of these sophisticated models to design the benchmark portfolio for the investment management of the Exchange Fund, taking account of our low risk appetite and high liquidity requirement, and making reference to a long series of historical data about the performance of a wide spectrum of financial markets. But the final structure of the benchmark portfolio is really not that complicated. It will inevitably be expressed as percentages of the funds to be held in deposits, debt and equity, and percentages to be held in the domestic and foreign currencies. These allocations would be supplemented by certain risk management parameters, such as the minimum credit rating of financial instrument issuers and the maximum proportion of the fund that can be put in a specific instrument of any issuer. The benchmarking process may be a lot simpler for individuals. If you do not have the technical knowledge to design your own benchmark portfolio, you can by-pass the highly technical process and arrive at your own allocation to deposits, debt and equities and the currency mix by referring to the published information of different types of funds. You should recognise that, generally speaking, investing a higher proportion in equities involves higher risks and a potentially higher rate of return.

As readers are aware, the benchmark portfolio of the Exchange Fund comprises 77% in bonds and 23% in equities, and 88% in US (and Hong Kong) dollars and 12% in other currencies. Readers may find it interesting to design their own benchmark portfolios having regard to their own risk appetite and liquidity requirement (which might be higher and lower respectively than those of the Exchange Fund) to see if they can achieve a higher return than the average annual rate of return of the Exchange Fund over the past seven years of 5.7%. Having designed your own benchmark portfolio, you can invest your money accordingly and make your own choices of individual financial instruments, for example, which stocks to buy and what bonds to hold. You should also spend some time assessing how well you are doing by comparing the overall rate of return you managed to achieve with the rate of return of your own benchmark portfolio. There are published indexes for each of the financial markets you invest in. For example, if you are investing in Hong Kong's Hang Seng Index stocks only, then the rate of return of Hang Seng Index will be your benchmark rate of return. If you are skilful in picking Hang Seng Index stocks, you will find yourself beating the performance of Hang Seng Index (achieving positive alpha in technical parlance) and you should congratulate yourself for doing a good job, even if the Hang Seng Index has fallen or you have lost money.

Benchmarking is a useful discipline in investment management.

Joseph Yam

15 June 2006

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