I was discussing last year’s equity returns with a good friend of mine and he mentioned that his advisor did quite well having returned 14%. Unfortunately, the corresponding index returned 18% over the same period.
One of the usually overlooked areas by investors is a valid measure of (fund) manager or advisor performance. And as soon as you say performance you must next ask the question “performance relative to what?” One of the Merriam-Webster definitions of a benchmark is “something that serves as a standard by which others may be measured or judged”.
For portfolios, performance is measured relative to some benchmark. So your assessment of performance of your U.S. stock portfolio, which returned 10% last year, may be “good”, “bad” or “so-so” depending on whether the S&P500 return was 3%, 15% or around 10%.
In investment management a benchmark must have certain properties. In CFA Institute’s “Managing Investment Portfolios: A Dynamic Process”, Bradley, Richards and Tierney specify certain necessary properties that a benchmark must posses to work well in performance evaluation. These properties are: unambiguous (known composition and weights), investable (can buy and hold the benchmark), measurable, appropriate (suitable for the manager’s style), reflecting current investment opinion, specified in advance and are owned (i.e. are accepted by manager and evaluator).
As to the type of benchmark, while there are many, to keep it simple we’ll focus on broad market index benchmarks. Examples of commonly used U.S. indexes (and readily available proxies) that can be used as benchmarks are: S&P500 (SPY), Wilshire5000 (VTI), Russell3000 (IWV) for U.S. equity or Lehman Aggregate Bond Index (AGG) for U.S. bond funds. For Canadian capital market S&P/TSX60 Index (XIU.TO) and Scotia Capital Universe Bond Index (XBB.TO)
So for a manager of large cap U.S. equities one may use S&P500 as a benchmark. Whereas for a Canadian large cap equity manager the S&P/TSX60 index would be more appropriate. Similarly, one could take the liberty to define an overall portfolio benchmark for a U.S. or a Canadian do-it-yourself investor whose Strategic Asset Allocation (SAA) is 50:50 stocks: bonds, to be the return of (0.5*stock + 0.5* bond) index that is applicable. One could do the same with a specified international content in the SAA, by using the MSCI EAFE developed markets index representing Europe, Asia and the Far East (EFA).
A caveat when using indexes to make sure that you compare apples to apples as indexes are available in various flavors such as with or without dividends, in local currency or in U.S. $ or may even be available hedged into Canadian dollars.
A manager of an equity or bond fund with a corresponding benchmark may add (or subtract) value by over or under weighting some stocks or bonds in the index or even including stocks not in the index. Value may be added (or subtracted) by an investor or manager by periodically changing the Tactical Asset Allocation (TAA), or by adding some extra weighting in Emerging market assets or gold or commodities; also by the investor’s rebalancing activity among asset classes or hedging, or not, the foreign currency exposure in the portfolio.
At the end of an investment interval, the investor should measure the performance and understand what contributed to the performance difference from the “benchmark” (performance attribution). (And, a topic that we’ll defer to a later occasion, should do a performance appraisal (luck or skill) of the manager, by looking at risk adjusted returns.
So when you are ready to launch your portfolio, or more likely now, as you probably don’t have a benchmark, years after you have been living with your evolving portfolio, you should set your benchmark. How else do you know how you, your advisor or your fund manager is doing?