August 21, 2022
Sid Roy
This month’s Ask-Learn-Share meeting was a change in some ways. We have been focused on talking about the foundations of a sound investment strategy for a while. We have been stressing about the importance of starting with goals in mind and a well-diversified portfolio to reach those goals. In this episode, we will talk about getting a sense of how well the portfolio is doing.
First, let us talk about portfolio benchmarking. What is it? An example from our school life might be a good way to get an intuitive understanding to start with. In our discussion, we came up with the example of a student who has scored let us say 75 points out of a scale of 100. Let us say the concerned parent of the student enrolled his child with a tutor. Let us say that in the next test, the student managed to score 80 points out of a scale of 100. Naturally, it looks better than the previous attempt. The parent might be happy that the tutoring session is helping. However, he is missing one thing. The child may have done well, but we do not really know if the child would have done the same or better without the tutor. Perhaps the new test was easier and everyone else got a bump in their test score, or the child was unlucky last year. How would we know? This is where we need to compare it to something. Perhaps, if we compare the average score achieved by the students in the class without tutoring might help. Suppose the average score is 80 in the first test and the average score in the second test is 90 for these students. It might make you think differently about what really happened. You will be right in questioning if the tutor really helped the student make any progress. This is because you now have a benchmark to compare the progress made with a tutor involved. You have done benchmarking for the strategy that the parent you used to get to his goal – better grades for his child. Portfolio benchmarking is the same concept applied to your investment portfolio.
In very similar manner, it is easy to misunderstand how well your investment portfolio is really doing unless you compare it with a benchmark. The analogy is even more applicable if you are using the services of an investment advisor to help you decide your investment portfolio. We frequently look at the changes in absolute numbers – let us say we see that we started with $10,000 and we ended up the year at $15,000. That seems like as good a return one can expect especially when you compare it with the historical returns of stocks that you hear about – around 5-6%. We do this rough calculation in our head, and we feel satisfied that we are getting the right returns. This is especially true if we have an investment advisor to whom we are paying management fees. We think that she must be doing great. This is where we might need to think counterintuitively perhaps and not look at the absolute improvement. Instead, we need to have a benchmark to compare. Was it really that great compared to some market indices for example? How much better did our portfolio do compared to a portfolio that might be just following a market index? In this hypothetical example, if the market index-based portfolio returned $16,000, then you clearly did not do well. This is the idea of portfolio benchmarking, and it is important to understand where your portfolio stands compared to alternatives such as standard index-based portfolios.
Many of us intuitively understand it. There is a common pitfall that we still get into that is worth mentioning here. We look at the market return of the indices and compare it against the return we see in our portfolio. The comparison is misleading because one is time-weighted return and the other is dollar-weighted return. A real portfolio sees deposits on an ongoing basis. Thus, the cumulative return is affected by the intermediate cash-flow. However, the market returns are usually reported based on performance of a fixed sum invested in the market at the beginning. This is something to watch out for. This can be a significant oversight especially if you are looking at absolute value changes in your broker website. By the end of this discussion, I also had doubts if I have been overly confident.
Naturally, my next question in this discussion was – do all of us need to do this regularly? I have not been that disciplined about it myself. The answer is as well always it depends. It depends on the style of investing. For the purposes of this discussion, it is helpful to create four types of investors – investors who have a passive approach to managing investments and their investment vehicles are also passive. We might call them – passive – passive. Then there are investors who have taken an active approach to managing their investments while they are invested in passively managed funds. We call them active – passive. Unless we think about it, we sometimes do not realize that we might be in this class. Then they are investors who are actively managing with a mix of investment of vehicle types. Except for passive-passive investors, every other type of investor should be looking at portfolio benchmarking. The passive – passive investor has decided on a particular risk–reward profile with a mix of assets. If that risk–reward profile does not change, portfolio benchmarking isn’t required. On the other hand, even a shift from one passive ETF to another passive ETF is a change, it is a type of active management. Bottomline, whenever there is active management of a portfolio, it is important to compare the returns against a benchmark. This means that most of us should be looking to benchmark our portfolio.
Now that we understand what portfolio benchmarking is at a high level, why it is important and who should do it, let us just get a bit more concrete. There are two things that make portfolio benchmarking a little tricky. One part is – what to benchmark against and the other is the period of benchmarking. Let us first consider what to benchmark against. Let us say that your portfolio is simply a 60:40 stocks – bonds portfolio. In your stock allocation, you have allocated 50:50 between large cap stocks and small cap stocks. In your bond portfolio, you have allocated to intermediate duration corporate bonds. Based on this breakdown, you need to find benchmarks. The simplest benchmarks to compare against would be the well-established ones in each class of investments. For example, Morningstar publishes such benchmark funds in each category. These can be a good starting point. If you have been switching between different asset classes frequently, this obviously makes things complicated. If you compare the overall portfolio to any of the common benchmarks, you have a sanity check.
The second aspect of benchmarking is – what is the window for benchmarking that is reasonable? This again can get tricky because – if you do it too often, it is meaningless on two counts. If you benchmark, then you should do something with the results i.e., change something in your portfolio. But doing it too often will incur taxes and hardly result in good results. If we believe that we are investing in the long term, then you should give it enough time to evaluate results. A 10-year period seems like a decent period to evaluate. At the same time, the obvious question is – does it give you enough window to make corrections? This is particularly problematic if you are evaluating performance with an investor.
Longer window seems more reasonable, but you have to contend with another issue. There are probably more deposits into your portfolio during that period which makes the process more complicated. One way of dealing with this complication is – if your deposits are not significant compared to your overall account, they can be ignored for the purposes of benchmarking.
One other approach to consider – if you can consider a part of your portfolio as passive-passive and a part (hopefully a smaller part) active, then you can do the portfolio benchmarking on that part. We should keep in mind – if you do not take the lessons from the active part of the portfolio and apply it to your main portfolio, then why do it in the first place?
Bottomline: Portfolio benchmarking is important to understand how you are really doing with your investment strategy. Investors who are passive – passive in their investments can get a more deterministic result on relative performance. It is good to start with a simple comparable index fund for your portfolio and compare performance over a reasonable period perhaps – 3-, 5- and 10-year comparisons might help to get a good picture.