Addressing questions including: Why is a benchmark important? How do we establish a proper benchmark?
Total Return vs. Yield Benchmarks: Which is right for you?
In one of our more vintage articles, we wrote about "Yield versus Total Return: The Great Controversy Solved," and pointed out that, in the long run, total return and yield approaches converge since, in the long run, 99+% of total return is due to yield. While congratulating companies focused on maximizing economic returns, we spoke of the importance of getting there by maximizing risk adjusted yield.
However, what about instructions to your investment manager? Do you ask the manager to beat the total return benchmark, realizing that in the short run this may not allow your company to achieve its annual income goals? Or, do you simply ask the manager to "get me the best yield," ignoring the importance of increasing the economic value of your portfolio? And, doesn’t "get me the best yield" open your portfolio up to securities that may pose unusually challenging and troublesome problems in the future?
How do you focus on maximizing risk adjusted yield while keeping the economics of the portfolio in mind?
We already have access to total return benchmarks from publicly available sources. Of course, these should be customized based upon your company’s liabilities, capitalization, as well as corporate goals and objectives.
However, how do we know if the manager is indeed providing the best performance on risk adjusted yield? By using a risk adjusted yield (RAY) benchmark.
Risk Adjusted Yield (RAY) Benchmark
The RAY benchmark can be used to determine the bottom line value being added or subtracted by your manager’s investment decisions.
Unfortunately, the RAY benchmark is not a benchmark that can be constructed solely from publicly available total return benchmarks. The RAY benchmark uses market yields of your company’s total return benchmark at the time of cash flow changes and factors in your company’s actual portfolio yield and any specific directives given to the manager. It is adjusted for credit losses or downgrades attributable to the total return benchmark. It can further be option adjusted to allow for differences in portfolio and benchmark convexity.
In this way, the RAY benchmark displays what the credit risk option adjusted yield should be on your portfolio and can be compared to the current portfolio’s credit risk option adjusted yield.
The difference between the portfolio’s risk adjusted yield and the RAY benchmark can be used to determine the current bottom line impact of investment decisions made by the manager. Since components of the RAY benchmark are related to the total return custom benchmark, total return over or under performance can be compared to risk adjusted yield over or under performance.
The difference in these two performance comparisons is the amount of over or under performance attributable to periodic, price changes due to primarily to interest rate factors. This will probably be the biggest reason for short term total return volatility. This difference can also be explained for what it is: a mathematical change in value due to a change in interest rates, not a true economic gain or loss.
Over a long time frame, value added from pure interest rate changes will become less significant and the fixed income portfolio’s less volatile source of value (option and credit risk adjusted yield), will be predominant.
The yield versus total return question continues to haunt insurers. Developing a risk adjusted yield (RAY) benchmark that fits your company’s goals and objectives is a key component in answering that question.