Expert panel: Why total portfolio performance is so noisy |
Many pension funds have underperformed simple portfolios of listed stocks and bonds in recent years.
If these are the results, the conversation may be turning on why they’re paying professional asset managers when they might be able to do it better themselves.
It’s a legitimate, intuitive and logical question. But it assumes a crucial point: that investment skill can be inferred accurately from past returns. This isn’t the case in the context of total portfolio performance. A new study published this year shows that drawing these conclusions proves to be more difficult than it appears.
A core principle of benchmarking is that a portfolio should closely align with its benchmark. In other words, it should exhibit low tracking error. When the portfolio and benchmark aren’t well aligned, it becomes extremely difficult to distinguish skill from luck because differences in returns are dominated by noise rather than signal.
Read: Total portfolio investor shouldn’t rely entirely on benchmark comparison: CPP Investments
Achieving close alignment is challenging in the context of total portfolio performance. A simple portfolio of listed stocks and bonds, commonly known as the “reference” portfolio, provides a natural benchmark because it represents a low-cost investment strategy that plan members could reasonably implement themselves.
In principle, pension funds should be well positioned to outperform this benchmark. By pooling members’ assets, they gain access to a broader range of investment opportunities than most individuals can reach alone. They can also employ teams of economists and analysts to develop informed views on future asset class returns and identify mispricing in financial markets, often leading to better-diversified portfolios and stronger........