London : If you don't have a benchmark what are you aiming at? If you don't have a target, how can you justify your reaction to good news or bad news in terms of your investment return?

As market "wobblies" continue and the press continues with its sensationalist-based service to investor sentiment by reporting market "tumbles" and "crashes"; perhaps this is a good time to log into exactly what a good performance is?

And while you might say: "we know it's about our individual attitude to risk/tolerance to loss", there are nevertheless a few important steps in the performance ladder that are often taken for granted. So, here we go up the performance ladder.

Step One: The basics — understanding inflation. Skip to step two if you know this, and if you have all your investments in cash, re-read step one several times. The first step in wealth creation is the continual increase in overall purchasing power. For this, the best performance benchmark is inflation — the rise in price of goods and services over time.

To establish which inflation rate you are trying to beat, you need a base currency. This must be the currency of end-use. So the Australian marrying an Indian, who want their daughter to be educated in the UK, and wish to retire between India and Australia, have at least three basic inflation rates to configure: the rise and price of UK education; and the rises of prices of their basic needs in Oz and India.

If they are earning UAE dirhams with its US dollar peg; they have an immense currency challenge, and hiding that challenge behind a US dollar benchmark, whilst convenient, is "well-dodgy" as they say in UK education.

So, at best, the base currency inflation rate should be considered as a minimum benchmark. Returns at the same rate as the inflation rate simply serve to sustain purchasing power and not to improve it. $100, (which might buy X bags of Lipton's tea today); left in cash and earning interest, may well be worth (say) $120 in five years, however, the number of teabags it buys will still be about X in five years. In short, cash is a means of exchange and a store of value. It's not designed (much to the confusion of some bankers, and especially their marketing departments) to improve purchasing power. Cash is a great asset for protecting, not improving purchasing power.

Risk free

Step Two: The risk-free rate. The risk free rate needs firstly to be understood as a theory. As Justice Putnam (in his Prudent Man Rule) noted: "Do what you will your capital is at risk". Depending on who you are tuning into the risk-free rate can be described as either the cash rate or, in the US and UK, government debt. In the US/UK government defaults over the last few hundred years have been few, and the short term issues taken as not long enough to create a systemic concern; in those environments, the risk-free rate is taken to be government debt. Good news for those currencies because at least the rate will be higher than cash rates (to justify the short term loss of liquidity), to the point where purchasing power must be improved a tad.

From this we can take that anything over and above the risk-free rate, is, in fact improving purchasing power at times when the return is over the risk-free rate. Now we are really "making money".

Step Three: Market beta. If we take US dollar inflation as our base currency inflation target (being pegged to the dirham it has an impact on UAE life), then we know from steps one and two that US dollar cash rates will sustain US dollar purchasing power, and Treasury Bills will give us a small improvement in US$ purchasing power. The fact that it doesn't translate easily into dirhams being one reason for the currency de-pegging debate.

Where do we go to get the improvement in purchasing power? Typically and traditionally, it would be the US stock market. Typical and traditional benchmarks or targets for this being: the Dow Jones, or the S&P 500 or the Nasdaq. All of these have been traditional "beta markers" for performance over time expected to beat steps 1 and 2 of our benchmark ladder.

More recently, the cheaper Electronic Trackers have become the cheapest form of finding the beta for both US markets and for other "betas" looking to improve purchasing power against minimum benchmarks. One theory that helps explain why is Eugene Fama and his Efficient Market Hypothesis. It assumes that in "efficient markets" the information gap is such that everything is known about prices and therefore markets are efficient. In such markets you might as well buy the cheap trackers to get your "beta" as the fund managers are unlikely to improve dramatically on market prices.

Step Four: In search of Alpha. This is where you would now expect market intelligence to be found. Steps 1 to 3 can now be achieved fairly straightforwardly and through highly average planning and wealth management techniques. Anything above beta is, these days, being called "Alpha". Like the "Alpha Male" gorilla theory, the Alpha fund managers purportedly do everything better than everyone else.

Great… but beware the following: firstly, successful fund managers tend to get head-hunted. RMB guesstimate that the average fund manager survives for three years. Secondly, above-beta performance is difficult to sustain and investors need to take rolling periods of time and not try to opt in and out.

Thirdly, above-beta performance is often due to isolated strands of brilliance and it's difficult to sell isolated brilliance to investors who would prefer to see brand-brilliance. Finally, the analyst/fund managers who consistently end up with brilliant performance often find it easier to work for themselves. No moans to listen to!

 

The writer is chairman of Mondial Financial Partners International.