Money: Take the right measures

Want to know how well your investments are performing? The secret is to choose the right measuring stick, finds Brent Sheather.



"It's easy to look tall if you stand beside a short person," an influential US fund manager once said.

He was referring to the practice of promoting investments by measuring their performance against some comparable - or in this case not so comparable - benchmark.

What is a benchmark? A measuring stick, by any other name. Or, in the words of Morgan Stanley Capital International (MSCI), one of the best-known suppliers of investment data, a benchmark is "a standard by which something can be measured or judged".

With investments, the benchmark will be an index of some sort, such as the NZSE-10 index, which measures the return from the local market's top 10 shares, or the Dow Jones Industrial average, the best-known measure of the US sharemarket.

While there are any number of stock, property and bond market indexes, not all make good benchmarks; the Dow is well known but it is a very poor benchmark for a number of reasons, among them the fact that it includes the stocks of only 30 companies, which are far from representative of the US economy.

If you choose the right benchmark, you can tell how well your investments are doing - better or worse than the market in general. In the case of a managed investment such as a unit trust, it tells you what you are getting for your management fees and how much risk your manager is taking on your behalf to get these returns.

Comparison with a benchmark is a key test for anyone considering investing in a managed fund, and there are some simple checks to make to ensure that the benchmark used is appropriate and the comparison is fair.

\EE Time periods need to be consistent. If your managed fund returns are for, say, the year, three years, five years and 10 years to the end of 1998, then your benchmarks must have the same start and end dates.

\EE Currency. Obviously if your fund's performance is measured in New Zealand dollars then your benchmark has to be similarly adjusted.

\EE Taxation needs to reflect your situation. Most local unit trust managers operate in an environment where their capital gains are taxed, so in their view the appropriate benchmark is one which has had its returns reduced by the applicable tax rate. While this comparison is fine for entities which must pay tax, the average Mum and Dad investors with $10,000 or $20,000 to invest most certainly do not have to pay tax on capital gains, so their benchmark should show before-tax returns.

\EE In the case of shares, dividends need to be included in both the benchmark and the fund being analysed. Not so long ago, a number of well known local fund managers used to compare their funds' performance - dividends included - with the NZSE-40 capital index, which excludes dividends. Very flattering, I'm sure! With the New Zealand sharemarket paying dividends of about 6 or 7 per cent, dividends are important.

\EE The orientation of the fund and the benchmark must be consistent. There is obviously no useful information to be gleaned from comparing apples with oranges but this happens all the time. At the moment, some local managers who invest a portion of their money in Australian shares continue to measure themselves against New Zealand benchmarks. If the Australian market performs well, a New Zealand fund with some investments in Australia will also do well, but does this make the manager more skillful - or just luckier - than the manager of a fund with all its assets in New Zealand shares?

"Benchmark abuse" occurs all too often. For example, a recent bulletin from a research organisation compares the performance of a number of "balanced" unit trusts - ones which invest in a balanced portfolio of bonds, property and shares - not with some index covering those categories but with consumer price inflation.

The balanced funds won hands down, far outpacing inflation.

But if you compared those same balanced funds with the performance of the relevant benchmarks - indexes covering bonds, property and shares - the story is very different; the funds performed worse than the markets they invested in.

There are many ways of making your fund look tall, and potential investors need to be wise to these marketing techniques.

Another example arises when fund managers compare their performance with a benchmark which is a far lower risk than their fund. Many glossy brochures compare a fund's performance with risk-free 90-day bank bills, for example.

Of course it's not a lot of use to know about the value of benchmarks if your fund manager, financial adviser or stockbroker does not provide them.

So where do you get information on key benchmarks? Obviously if you are dealing through a financial adviser or broker who is going to get a fee from you for selling you a managed fund, this must be your first choice.

Indeed, if you are paying a 2 or 3 per cent fee or commission it is reasonable to expect a second opinion as to why your adviser has chosen these particular funds for you - comparison with a benchmark does that without risk of bias and with absolutely no obligation.

The Herald provides "raw" benchmark data for a range of markets including local and Australian shares, and global equities via an MSCI global index. That MSCI index, however, is a "capital" index (one that does not include dividends) and it is in US dollars, so some adjustments are necessary. All these indices are pre-tax.

There are no doubt many other sources available on the Internet.

The annual reports of most British-based investment trusts listed on the New Zealand sharemarket include a graph of their performance relative to one or two benchmarks, usually accompanied by the chairman's explanation for any divergence - long drawn out affairs if the fund is outperforming, terse excuses if not.

Consistency is the name of the game when picking the right benchmark, but for a fair comparison you can't just compare the performance of the benchmark and the managed fund.

That is because to be sure your investments are diversified, you usually have to buy into a managed fund of some sort and even doing that the cheap way - via an index fund - means paying fees of 0.5 to 1 per cent a year.

So you must deduct that much from the benchmark to come up with the sort of return you could expect to receive if your investment just matches the market overall.

Some of the more common benchmark indexes and their returns for the period to the end of May are listed in the table.