Investors expect their investments to outperform the market. With interest rates rising, that expectation may mean they are taking on more risk than they should.
When the US Federal Reserve signalled earlier this summer that it may begin to pull back on its quantitative easing programmes, interest rates jumped and equities swooned. As the dog days of summer draw to a close, investors may wonder how to evaluate their investments. When investors are evaluating an investment product, they often ask, “How does its performance compare with the market benchmark?”
This seems like an entirely reasonable question. Investors are willing to pay a manager for improving investment returns and comparing returns with market indices is a good way to judge the performance of various investment products.
The Oxford Dictionary defines a benchmark as “a standard or point of reference against which things may be compared.” For example, Octane rating is a standard measure of the performance of gasoline. It compares the quality of the fuel you buy at the pump with an ideal fuel. Regular gasoline with an Octane rating of 87 provides 87% of the performance of pure Octane.
While pure Octane is an ideal fuel for the engine in your car, market benchmarks are not designed as ideal investment vehicles. Consider the S&P/TSX Composite Index, an index of the stock prices of the largest companies on the Toronto Stock Exchange (TSX) as measured by market capitalization. The Toronto Stock Exchange listed companies in the index comprise about 70% of market capitalization for all Canadian-based companies listed on the TSX.
The challenge with using the S&P/TSX Composite Index is that, far from being a benchmark or investment ideal, it simply reflects the nature of business in Canada. And what business is Canada in? You have likely heard the expression that we are ‘hewers of wood and drawers of water.’ In fact, resource companies (combining the energy and materials sectors,) comprise about 50% for the market capitalization of the TSX Composite Index.
That concentration in the resource sector means that the S&P/TSX Composite Index is highly volatile. For example, as commodity prices rose in 2009, the TSX moved up sharply. With commodity prices falling this year, the TSX has exhibited higher volatility and poorer performance compared with US markets.
Investors expect and even demand that fund managers earn their keep by out-performing market indices. In order to do that, managers must take on more risk. However, if a fund out-performs in a rising market, it will likely under-perform in a declining market. That’s exactly what many Canadian investors experienced in 2008: while the TSX Composite Index declined by 33%, many supposedly conservative large-cap equity funds declined by 40% or more.
Many investors will claim that they are aggressive investors when markets are rising. But when markets fall, they find they are in fact risk adverse. Daniel Kahneman and Amos Tversky founded the field of behavioral physiology. They studied how people manage risk and uncertainty and concluded that investors are not so much risk adverse as they are loss adverse. They summarized their research by saying that “losses loom larger that gains,” in investors’ minds.
A robust portfolio should include high-quality dividend stocks diversified across the various sectors of the economy. On the fixed-income side, investors should hold bonds with short durations to limit the effect of interest rate hikes. We believe that over the next business cycle, equities will be the preferred asset class as the recovery gathers momentum and interest rates continue their assent.
Read more about interest rates and markets in our Second Quarter Commentary
You can read a good discussion of this topic at The Passive Income Earner