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Benchmarking: A small investment with a big payoff

November 2018
By Daniel McIntyre, Vice President Investment Services at Corporate Central Credit Union and QuantyPhi

As 2018 draws to a close and the budgeting process for 2019 begins, credit unions are making decisions about how to best invest their money in the year ahead. QuantyPhi saw a steady increase in the number of credit unions investing in portfolio benchmark-building over the course of the current year, and we expect that trend to continue. More and more credit union leaders are realizing that the small dollar commitment that benchmarking requires has a long-term big payoff in the form of better financial results, wiser investment decision-making, and more accurate investment manager performance measurement. It’s important to note here though, that earmarking funds for benchmarking is only half of the benchmark-budgeting process. A small investment in time is also a key factor, as credit union leaders must be given time to learn how to best use each year’s new and unique benchmarks. Portfolio benchmarking is the tool that helps financial decision-makers better understand how balance sheet decisions will impact the financial health of their credit union. Time invested in the understanding and usage of those benchmarks provides the knowledge necessary to use the tool effectively.

What exactly is portfolio benchmarking?

A benchmark is a target. Portfolio benchmarking is the process of setting targets that pave the way to performance success. It is used to help credit unions understand what investment characteristics are necessary to assure consistent, high-level performance. It also provides investment managers and supervisors with the means to accurately measure how well the credit union is doing. Most commonly used for the investment portfolio, benchmarks help define how any particular investment should perform. Benchmarking also clarifies the risk position and facilitates income forecasting within multiple interest rate environments. Once we understand the needs of the balance sheet in terms of interest rate risk exposure and income generation, we can use those needs (the benchmarks) to guide portfolio decision-making and to later measure the results of each investment decision.

How to build a benchmark?

In order to properly develop a benchmark, a credit union should first define the measurement it will use to evaluate portfolio manager performance. For equity investing, this is a simpler undertaking. For credit unions, however, this takes a little more reflection. Credit unions are restricted from many investment alternatives that are included in several market indexes, so we have to look at how to build a benchmark that is appropriate to each individual credit union’s unique needs while working within those restrictions. According to C. Mitchell Conover, a benchmark should contain the following characteristics:

  • Unambiguous
  • Investable
  • Measurable
  • Appropriate
  • Reflective of current opinions
  • Specified in advance
  • Accountable1

At QuantyPhi, we suggest building benchmarks using the most basic investment portfolio characteristics, making sure that those characteristics meet the criteria listed above. This passive benchmark can be built using listed U.S. Treasury securities in a laddered portfolio. The laddered approach allows financial managers to readily see the impact of their decisions relative to a “decision-free” portfolio. By using multiple benchmarks, with each benchmark representing a slightly increased exposure to interest rate risk, the manager can also see the tradeoff of additional income gained with the acceptance of higher rate risk. Once the potential impact of higher rate risk on financial performance becomes clear, all those involved in the decision-making process will be able to make more informed decisions regarding how to position the portfolio for optimal gain in all rate scenarios tested. That means everyone will be on board with how to position the portfolio for maximum returns while staying within risk constraints.

As stated earlier, developing a proper benchmark requires only a small financial investment, but making that benchmark useful also requires an investment in the form of time—time for leaders to understand the benchmark characteristics, time to learn how to use the benchmark to achieve goals, and time to relay that information to appropriate supervisory groups like senior management, board members and ALCO members. In addition, budgeting for the time and energy needed to explore, develop, and properly use benchmarks will help both the investment manager and the manager’s supervisors succeed. Providing the manager with a proper financial-performance road map regarding expectations, combined with risk constraints mandated by ALCO, will help keep the manager focused on critical performance targets and measurements. Setting targets for the investment manager through benchmarking assures ALCO that the manager will maintain approved risk limits and still deliver acceptable returns for a number of possible rate scenarios. 

Portfolio benchmarking is on the rise because it delivers big payoffs for a small price. Credit unions that invest money and time in portfolio benchmarking will make 2019 performance goals more attainable. They will make the road to success a clearer path, and they will stay optimized for peak performance under various rate environments.