How should I measure my investment performance? This is the question most commonly asked of an investment counsellor. The starting point in answering this question is to ask another question "To what should I compare my investment performance?"

Why Not Measure Performance Against the Indices?

Investment statements generally show standard indices as benchmarks as they are most recognizable to private clients (the TSX, S&P 500 and EuroStoxx 50 equity indices, for example). The media bombards us with the index returns so it is natural to want to see how our portfolio compares. There are a couple of problems with this approach. Firstly, equity indices are not directly investable - you can buy index funds and index based ETFs (exchange traded funds) but must pay a management fee to do so - a subtle but important point. Secondly, your portfolio can only contain a fraction of the companies actually listed in the indices. So no matter how you decide to invest, your portfolio will never perform, nor should it be measured, against the standard indices.

There are three comparisons that need to be made:

1. Your Portfolio Performance Compared to Your Investment Objectives

At the outset of any relationship between an investment counselor and a private client, there is an in-depth discussion on the subject of investment objectives and constraints. The discussion is summarized in your Investment Policy Statement (IPS). This document acts as a reference point for regular portfolio review meetings and reflects your investment objectives. The most common points addressed in an IPS are:

Return requirements - What is the annual after-tax rate of return that I am attempting to obtain and why? Is there any need to withdraw income from the portfolio? Generally there is a reference to inflation and the fact that any long-term portfolio must be designed to maintain its purchasing power over the years.

Risk tolerance - What is your history in managing market volatility and uncertainty? This is the most difficult factor to determine as personalities often reveal themselves only when truly tested - it is most important to discuss past investment experiences and the associated reactions.

Time horizon - Most often 7-10 years is considered a long term horizon, but depending on your situation, you may need to consider two or three different time horizons. For example, upon retirement you may need to begin withdrawing a percentage of your portfolio each year. The majority of the portfolio, however, will likely remain invested for another 20 years or more. In this case, the first time horizon is retirement and the second time horizon is when the entire portfolio is either liquidated or transferred to the estate upon death.

Legal and regulatory concerns - The portfolio must be structured to satisfy various rules pertaining to specific accounts.

Tax considerations - Your personal tax situation is a key consideration throughout the portfolio management process. Often there are unrealized capital gains or tax loss carry forward that must be properly managed. All attempts should be made to minimize negative tax implications in trading.

Unique preferences - This is anything specific to your personality or life situation that may have an impact on how your portfolio is structured. For example, you may have an emotional attachment to a particular company and a desire to retain it in the portfolio at all times. Or perhaps you have an aversion to "sin stocks" - those profiting from tobacco or alcohol.

When measuring performance compared to your investment objectives, you need to assess whether each item in the IPS has been adhered to in the manner originally agreed upon. Have all points been considered or have there been decisions made that are not consistent with the plan? This involves a frank discussion between you and your investment counselor.

2. Your Manager's Performance Compared to the Competition

Depending on who you are speaking with (investment counselor, neighbors, work colleagues, bank tellers, etc…) your perceived competition could be anything from an investment in a GIC that has returned 2% over the past few years to a complex hedge fund that has returned 50% over the past few years. How do you make this distinction? The benchmark must be RELEVANT.

A relevant benchmark is one that:

a) is investable;
b) has a similar investment style to the manager; and
c) is recognized.

Let's use the example of a Toron global equity mandate. Toron's core equity philosophy is to invest in companies that have strong cash flow, manageable debt and a reasonable valuation. A relevant benchmark in this case is a cluster of global fund managers with a similar investment style. Performance results should be compared on an annual basis against this peer group to determine comparative returns. This peer group benchmark must:

a) be investable (i.e. anyone can invest in the global funds in the peer group);
b) have a similar investment style to the manager (global equities is the easy part - similar philosophy is more difficult); and
c) be recognized (performance of global equity funds is reported regularly).

Using the same global equity example, let's consider benchmarks that would not be relevant. It is not relevant to measure your equity manager's performance against:

a) a treasury bill or GIC return;
b) an equity manager with a different style (e.g. hedge fund); or
c) an entirely different market (e.g. real estate or commodity futures).

It is important to take responsibility for the fact that you agreed to a certain mandate as part of a long-term strategy that made sense to you. Measure performance accordingly.

3. Your Manager's Adherence to the Portfolio Management Process and Discipline Compared to the Original Sales Pitch

We are getting away from the sexy stuff here but this is an important point. This is likely the most important factor to long-term portfolio performance.

Proper portfolio management involves patience and discipline. Most good managers profess to many of the following portfolio management disciplines:

a) regular rebalancing;
b) keeping turnover to a minimum;
c) dividend reinvestment;
d) ensuring that stocks are in non-correlated lines of business and have exposure to different areas of economic activity (global diversification); and
e) monitoring portfolio beta weightings

When discussing performance, be sure to review the agreed-upon process with your manager. If there are gaps, this may imply negligence.

The biggest value-add that a manager offers is the discipline to remove emotion from the investment process and employ proper portfolio management techniques.

How Often Should Performance Be Measured?

It can be tempting in today's world of rapid-fire information and instant gratification to review performance too frequently. Expectations for consistent outperformance are out of line with reality if you have selected a strategy for the next 7-10 years. An annual review is reasonable. You need a few years to make a meaningful judgment of the success of your manager's performance.