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Looking for a Benchmark? Take the obvious one: Client Satisfaction

Looking for a Benchmark? Take the obvious one: Client Satisfaction

Anyone who manages client investments is committed to satisfy client’s investment goals. Yet when launching

a new investment strategy or implementing a mandate, the question about the benchmark usually revolves

around which existing index or combination of indices best represents the investment universe. The

discrepancy between the benchmark selected and client satisfaction is often significant. We present a simple

benchmark framework based on client satisfaction.

A wealth manager sitting down with a new client or a fund manager before launching a new fund often have a

hard time figuring out the appropriate benchmark. Usually, the benchmark chosen represents the closest

approximation of the investment universe covered or a combination of indices that the manager is expected to

outperform. While both approaches sound reasonable there can be a significant discrepancy between these

benchmarks and client satisfaction.

Classical scenario

Let us take a balanced portfolio approach to demonstrate the discrepancy. The wealth manager suggests the

combination of an equity index and a government bond index with weights of 60% and 40%. Rebalancing back to

the target weights is done each year (do not neglect the effects of rebalancing). Showing the client how this

benchmark would have performed over the last 20 years should clear all doubts. The absolute return achieved is

significantly positive, the major equity market drawdowns are smoothed by rising bond prices, and finally the

trend for these return and diversification characteristics looks unbroken. At this point the client starts to forecast

implicitly because he projects past performance into the future. The major concern at that time might be the skill

of the manager to outperform (or even just match) the benchmark and not the benchmark’s future performance.

This forecast is dangerous, not only in an environment of rising interest rates. We believe the client cannot assess

upfront if he will be satisfied with the manager’s performance against the benchmark. Underperforming a

benchmark with an extraordinary high return will usually deliver higher utility to an investor than outperforming a

benchmark with negative returns. Also, the lower the risk assumed to achieve these returns, the higher the client

satisfaction.

A simple framework

For a simple framework to measure client satisfaction we make some reasonable assumptions based on common

knowledge and behavioral patterns. Higher absolute returns and lower risk are preferred. Risk is not easy to

determine. Certainly, time in combination with a risk measure plays a role. We define that an investment strategy

which is able to recover losses more quickly dominates another that shows the same magnitude of losses but fails

to recover in the same time. The toughest ingredient to anticipate for client satisfaction in the future is the

relative performance. Stating in advance that high absolute returns are most important, clients may be partly

disappointed by negative relative performance. We could imagine that in countries where equity market

participation is high (and you hear people talk about their best stock picks or expect your neighbors to hold the

market portfolio) relative performance is more important.

Summed up in a chart, we conclude that clients care most about absolute returns and a little bit less about

relative returns in the long-term. On a very short time horizon - independent from the manager’s performance -

clients will not get extremely happy or angry because short-term returns are no guide for the future. On a mid-

February 2014

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Looking for a Benchmark? Take the obvious one: Client Satisfaction

term horizon clients are unhappy with negative returns, either absolute or relative ones. They are a bit more

optimistic if the manager at least delivers positive relative returns.

Chart 1: Client Satisfaction based on absolute and relative returns over three time horizons

©C.h.r.i.s.t.i.a.n.S.c.h.u.s.t.e.r.Q.A.P.a.r.t.n.e.r.s.

An example: comparing two equity strategies

To make the concept clear with an example, look at two equity strategies. One is a multi-strategy approach on

global equities, the second is a passive strategy on the US equity market. You start with the client (or investor

target group) to determine the return goals upfront. These goals are stated in satisfaction points. Here, we

assume an investor would be 100% (=100 points) satisfied with annual returns of 15%, would be indifferent at 2%

and 100% angry when losing 5% annually. Although increasing and decreasing utility for certain areas of return in

the calculation would represent a more realistic picture, we assume a linear utility function here.

For measuring risk, or better defined as investor’s pain, we use a measure similar to the ulcer index. This measure

captures magnitude and length of drawdowns and therefore indicates the pain felt by investors. For a long time

horizon we take three years being aware that a far longer time period should be chosen (and shorter periods

should be incorporated, too). A relative return measure against an index is neglected for simplification. Return

has a weight of 75% and the pain measure contributes 25%. The question why we only weight pain with 25%

might come up. In the end, after a long-term investment horizon all that counts for an investor is the absolute

return, but the influence of negative emotions felt in the meantime should also be included. Therefore, we only

add the satisfaction points from three year absolute returns (rolling) and from the risk figure to arrive at our client

satisfaction measure.

Starting in 2007 both strategies were on a high satisfaction level thanks to rising stock prices with no major

setbacks in the previous three years . Already at the start of 2008 the passive strategy takes a dive that only ends

in Mid-2009 on a very low satisfaction level. From Mid-2009 on the passive strategy scales up but it takes until

2012 just to get back into territory where we believe the client’s feeling would be neutral. Looking back from

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Looking for a Benchmark? Take the obvious one: Client Satisfaction

2014, the passive strategy did not manage to stay on a level of 100% satisfaction for more than a few weeks,

although the US equity market exhibited an enormous increase to new highs over the last five years (remember

we just included three years into the formula). The pain felt, measured by drawdown severity (e.g. US ratings

downgrade in 2011), was a drag on increasing satisfaction.

Chart 2: Client satisfaction for two different equity strategies

©C.h.r.i.s.t.i.a.n.S.c.h.u.s.t.e.r.Q.A.P.a.r.t.n.e.r.s.

In contrast the multi-strategy global equity approach managed not only to stay in positive satisfaction territory

during the complete observation period, it was also above 100% satisfaction the majority of time. Clearly, the

multi-strategy approach delivers the higher absolute return and more constant annual return figures but the

favorable risk metrics contribute significantly, too. Although you can see drawdowns for that strategy in the chart,

these are manageable in a sense that the magnitude of the drawdowns is low and the time to recover is short.

Conlusion

In its simplest form this benchmark model only requires one return and one risk figure to bridge the gap between

the claim to achieve client’s investment goals and measuring client’s satisfaction. We understand that this

concept is most applicable for balanced portfolios or broad mandates but it can also be utilized for other

strategies. Why not link performance fees to such a client satisfaction benchmark? A performance fee model that

shares the same logic, is easily employable, and aligns manager and investor interest can be found in the paper

“Better Alignment of Interests through Risk-Adjusted Performance Fees”.

QAP Analytic Solutions

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