The Importance of Benchmarking

The S&P/ASX200 TR index (my preferred benchmark) finished calendar 2010 at 34,518.53 points.  If you are a market follower, you will have heard many commentators saying the market was down in 2010.  This is a mistake often perpetrated on an unsuspecting market by an (in my opinion) uninformed ‘commentariat’.
The S&P ASX 200 did finish calendar 2010 down 2.57% on its 2009 finish, however the S&P/ASX200 TR index finished up 1.57%.  How is this? Well this simply means that dividends accounted for 4.14% of the total return for the ASX200 in calendar 2010.  This is not a new phenomenon, Australia is, and has been for some time one of the highest dividend paying share markets in the world.  The difference between the Price (S&P/ASX200) & Total Return (S&P/ASX200 TR) index over the last 3 years was 4.19%, over the last 5 years, it was 4.40%.  By way of comparison, US markets return less than 2% annually on average to investors as dividends.
Given the comparatively high Australian dividend returns, it is all the more important we consider them when deciding how our market has performed.  I consider the ASX200 (and the All Ordinaries and other ‘price’ indices) to be completely invalid measures when it comes to benchmarking, because when it comes to measuring returns, if dividends aren’t part of your ‘return on investment’, then what are they? Whether you choose to reinvest the dividends or not is your choice, but they must make up a part of your performance measure.
In my opinion in the area of performance measurement, there is no more important concept than benchmarking.  Imagine I were a pretty fast 100 metre runner (I’m not), had I beaten everyone I’d ever raced, and my best time was an extremely impressive 10.3 seconds, were it not for benchmarking, I’d possibly consider myself one of the fastest men alive.  Based on all recent evidence, this would be a reasonable conclusion.  Benchmarking, however tells me that my best time, a 10.3 second 100m dash would not be fast enough to have qualified for the most recent Olympics and therefore, there must be many who are faster than I.  Benchmarking myself against, for example the Australian 100m girls under 14’s record would also be unsuitable.  To be a valid performance measure, a benchmark must be 2 key things. Firstly, a valid measure of performance and secondly, nominated in advance of the performance occurring.
When it comes to benchmarking performance for Australian Equity fund managers, unless they are operating in a specific sector, such as listed property, or resources, the only suitable benchmarks will be the accumulation indices, either ASX200/ASX300 or All Ordinaries.
A quote I like that demonstrates the importance of benchmarking is made by Warren Buffett: “one must avoid the error of the preening duck that quacks boastfully after a torrential rainstorm, thinking that its paddling skills have caused it to rise in the world. A right-thinking duck would instead compare its position after the downpour to that of the other ducks on the pond”.
Believe it or not, since 1980, on a dividend-reinvested basis (over calendar years), the total return indices have exceeded 20% on 11 occasions (greater than 1 in 3 years). They have exceeded 40% on 5 occasions (nearly 1 in 6 years – though the last time was 1993). In these years, it is possible for investors to be substantially duped if their fund manager does not benchmark to an appropriate index.  An uninformed investor whose fund manager has grown his portfolio by say 38% could be compared to Buffett’s duck if the market has advanced by say 44%.

Believe it or not, some funds (though not many) use the ASX200 (rather than the TR index) as their benchmark.  This immediately gives them over a 4% advantage, so they could take a hefty annual management fee, track the benchmark closely and still report above benchmark performance.  Worse still are the ‘absolute return’ funds, without naming names, I have seen examples of these that charge 2.5% p.a. management fees, have a benchmark of 0% (they don’t even give you CPI) and charge 25% ‘out-performance’ (is beating 0% really outperformance?) fees, they comfort you by not charging fees until any capital losses (in years they decline) have been recouped. Given that the Australian market has advanced about 12.5% p.a. over the last 30 or so years, such a fund, had it exactly matched the benchmark returns would have left you with a return of about 7.5% over time. Over 30 years, $1 invested at 12.5% p.a. will become $34.24, whereas invested at 7.5% p.a. it would become $8.75, the difference would be in your fund managers pocket, so take care when investing in managed funds (or super for that matter). Now the weekly readership is growing, anyone with anything they would like me to address specifically is welcome to contact me by e-mail:– Tony Hansen – 24/01/2011.