Measuring Up: Benchmarks and Your Portfolio

A young boy is looking forward to growing and getting bigger.

Topic: Investments

R. Denys Calvin, CFA

July 23, 2019

Image used with permission: iStock/RichVintage


Print & Share

Print

Measuring Up: Benchmarks and Your Portfolio

An investor ought to be able to get answers to two simple questions: how has my portfolio performed, and what have I paid for that performance? Though there is plenty of arithmetic that goes into producing them, the answers can and should be as straightforward as the questions.

An investor ought to be able to get answers to two simple questions: how has my portfolio performed, and what have I paid for that performance? Though there is plenty of arithmetic that goes into producing them, the answers can and should be as straightforward as the questions.

A reasonable next question is “Why did my portfolio perform that way?” An insightful answer requires some context. We need a yardstick, reference, or “benchmark” to make an informed commentary on why a portfolio performed as it did.

bench·mark, n. a standard or point of reference against which things may be compared or assessed.

If your capital were all on deposit in a bank account or term deposit, you would have very different expectations for its performance than if it were invested in a portfolio of stocks. You might anticipate that the stock portfolio would earn a higher return than the interest rate on the deposit. For sure you would expect the month-to-month returns on the stock portfolio to be less predictable than the interest rate.

But that’s a pretty simplistic and blunt comparison. We need something a bit more informative and nuanced. For example, is the bank interest rate higher or lower than the rate of inflation? In this comparison, the inflation rate acts as a form of benchmark. The comparison to a benchmark provides some insightful context. If we’re earning less than inflation, then we know that over time the real purchasing power of the bank deposit is going to erode. We may have more money in the future. But it will buy less.

When it comes to a portfolio of securities, whether stocks, bonds or both, it would be handy to have a similarly informative benchmark – one that could help answer questions like the following. Did my portfolio have great returns simply because the market was soaring? How risky is my portfolio? Are the wild fluctuations in my portfolio’s returns warranted, given the way it’s invested? Am I getting my money’s worth for what I’m paying my investment manager? Moreover, we should be able to vary our time frame, and consider these questions over short, medium and longer time periods.

Enter the “market index benchmark”.

A market index benchmark is the hypothetical return from investing in one or a combination of market indices, such as the S&P/TSX Composite or S&P 500. It represents the return an investor could theoretically earn if they owned a portfolio comprised of, for example, all the stocks in the S&P/TSX Composite index – in precisely the same proportions as in the index, and incurred no expenses to acquire, hold or dispose of those stocks.

There are a few simple properties we should want a benchmark to have.

  • First, it ought to be reasonably representative of the portfolio with which it is being compared. For example, comparing the returns on a 91-day Treasury Bill index to a portfolio of U.S. stocks is not especially informative.
  • Second, a benchmark ought to be comprised of readily available, specific and recognizable underlying market indices. Even if it had significant explanatory power, an index of the 24-month moving average of the hemline lengths in 4-star Manhattan hotel cocktail bars every second Friday night would hardly qualify.
  • Third, a benchmark ought to be consistent from period to period so that comparisons between it and the portfolio are not obscured by repeated changes in the benchmark. It’s difficult to plot the growth in a child’s height over 15 years if you keep changing the measuring stick every 18 months or so.

For the Nexus North American Equity Fund, we use a market index benchmark that is a blend of three underlying indices in fixed proportions:  the 91-day Government of Canada Treasury Bill Index (5%), the S&P/TSX Composite Total Return Index (50%), and the S&P 500 Total Return Index measured in Canadian dollars (45%). While these proportions – 5-50-45 – don’t match the underlying investments of the Fund perfectly, they accurately reflect the long-run allocation pattern to those three major asset classes. The Fund generally holds cash and short-term money market securities equivalent to between 0% and 10% of its portfolio, although the position has run up above 20% in the past. Canadian equities have nearly always accounted for between one- and two-thirds of the Fund’s portfolio. And U.S. stocks typically represent between 15% and 50% of the Fund’s investments. In addition to these, the Fund currently holds between 8% and 12% of the portfolio in non-North American equities.

All the component indices in the benchmark are widely published and well recognized. Moreover, each is itself “investable” in the sense that it is completely feasible to find index funds or exchange-traded funds designed to mimic each of these indices, and invest in them in the same proportions as represented in the benchmark.

Finally, the benchmark has remained the same since inception of the Fund 22 years ago. The actual asset mix of the Fund has fluctuated widely over that period, almost never matching the 5-50-45 proportions that each of the three underlying market index represents in the benchmark. And the benchmark contains no representation for international (i.e., non-North American) equities despite the Fund having long had between 5% to 10% of its assets invested there. But having maintained the same benchmark throughout, the Fund’s track record can be evaluated over any time period. It’s possible to assess whether our straying from the benchmark weightings has added to or detracted from the Fund’s performance, whether the Fund’s returns are more or less volatile (i.e., variable) than the markets it is primarily invested in, and whether the trade-off between Fund’s returns and risk (as represented by the volatility of returns) has been beneficial for the Fund’s unitholders.

There is an argument for adjusting the benchmark when there is a profound change in the Fund’s asset mix or strategy. In mid-2015, when Canadian equities fell to between 33% and 36% of the Fund’s assets – far below the 50% weighting in the benchmark – a critic might have declared the benchmark no longer representative and therefore inappropriate for comparison. But there had been no permanent shift in the Fund’s strategy to warrant a change, and, indeed, the dip in the Canadian equity allocation proved temporary. Now it’s back to between 42% and 45%, and comfortably larger than the Fund’s 35% to 40% position in U.S. stocks.

This tension about the representativeness of a benchmark, especially when the composition of a portfolio drifts or differs meaningfully from that of its benchmark, highlights an important issue. The simple comparison of portfolio-level returns with the overall returns of a benchmark merely scratches the surface, analytically speaking. A fuller understanding of why a portfolio has fared differently than its benchmark involves a much deeper, multi-layered analysis.

For example, perhaps the portfolio had a much smaller investment in Information Technology stocks than the benchmark during a period when that sector had a big influence on the benchmark’s performance. Or maybe the portfolio’s overall investment in such stocks was the same as the benchmark’s, but the portfolio manager managed to avoid the 3 worst performing ones. These are worthwhile things to identify and understand. But they may not be readily visible from the surface.

That a more nuanced and detailed analysis is required to tease out these types of insights is not a shortcoming of an imperfect benchmark. Rather, it illustrates that the usefulness of an appropriate benchmark goes far beyond simply how closely it “matches” the portfolio it is compared with, even if that additional utility comes only after applying more analytical effort and skill.

More Like This...

See another CRM2 blog post that may be of interest to you.

CRM2: The Nexus Approach to our CRM2 Reports

Topic:
CRM2
Excerpt:
With changing securities regulations coming into effect, investment firms are now required to provide individual investors with specific additional in

More Like This...

See another Foundations & Endowments blog post that may be of interest to you.

Charitable Giving Made Easier

Topic:
Foundations & Endowments
Excerpt:
Giving to charities and supporting our community are important to us at Nexus. We donate a portion of our management fees back to the charities and

More Like This...

See another Human Interest blog post that may be of interest to you.

The Case for Openness – An Open and Shut Case?

Topic:
Human Interest
Excerpt:
From time immemorial, mankind has been open. Open to new ideas, open to trade, and open to migration – the three critical ingredients for progress.

More Like This...

See another Inside Nexus blog post that may be of interest to you.

The Nexus Growth Spurt (Pandemic Edition) Continues!

Topic:
Inside Nexus
Excerpt:
As Nexus continues to grow, we remain committed to maintaining the highest levels of client service. This requires an ongoing investment in talent and

More Like This...

See another Investments blog post that may be of interest to you.

The End of an Era – Inflation is Back!

Topic:
Investments
Excerpt:
Inflation talk is dominating the news. It is on the mind of the man in the street and investors alike – and not just in North America or the lands of

More Like This...

See another Pearls of Wisdom blog post that may be of interest to you.

“Work, Work, Work, Work, Work, Work”

Topic:
Pearls of Wisdom
Excerpt:
This has been a busy year. I’ve had lots happening on the home front (a wedding!) and lots going on at the office (too long to list!) Managing work

More Like This...

See another Tax Planning blog post that may be of interest to you.

Saving in my Professional Corporation – It’s a Great Idea!

Topic:
Tax Planning
Excerpt:
The ability for professionals in Canada to incorporate their practice has existed for some time. Doctors, dentists, lawyers, accountants, and other

More Like This...

See another Wealth Planning blog post that may be of interest to you.

Dentists Get Their Financial Check-Up: Nexus attends the 2022 Ontario Dental Conference

Topic:
Wealth Planning
Excerpt:
In early May, we had the opportunity to attend the Ontario Dental Association’s (ODA) Annual Spring Meeting (ASM) in Toronto. Now in its 157th year,

On a Side Note…

See another CRM2 Nexus Notes Quarterly article that may be of interest to you.

No posts found.

On a Side Note…

See another Foundations & Endowments Nexus Notes Quarterly article that may be of interest to you.

Donor Advised Funds: An Overview

Topic:
Foundations & Endowments
Excerpt:
As we approach the end of the calendar year, taxes and charitable giving inevitably surface as ”things to do” in peoples’ minds. Here, we’d like to

On a Side Note…

See another Human Interest Nexus Notes Quarterly article that may be of interest to you.

The Case for Openness – An Open and Shut Case?

Topic:
Human Interest
Excerpt:
From time immemorial, mankind has been open. Open to new ideas, open to trade, and open to migration – the three critical ingredients for progress.

On a Side Note…

See another Inside Nexus Nexus Notes Quarterly article that may be of interest to you.

The Nexus Growth Spurt (Pandemic Edition) Continues!

Topic:
Inside Nexus
Excerpt:
As Nexus continues to grow, we remain committed to maintaining the highest levels of client service. This requires an ongoing investment in talent and

On a Side Note…

See another Investments Nexus Notes Quarterly article that may be of interest to you.

The Long and Winding Road

Topic:
Investments
Excerpt:
Reading the newspaper is an unsettling activity these days. In almost every facet of life there is a concern that can rattle even the most stoic

On a Side Note…

See another Pearls of Wisdom Nexus Notes Quarterly article that may be of interest to you.

A Table for None, Please; Working From Home on the Rise

Topic:
Pearls of Wisdom
Excerpt:
Reading is one of the principal occupations in our profession. As we digest a wide range of material, interesting ideas and surprising facts – some

On a Side Note…

See another Tax Planning Nexus Notes Quarterly article that may be of interest to you.

Saving in my Professional Corporation – It’s a Great Idea!

Topic:
Tax Planning
Excerpt:
The ability for professionals in Canada to incorporate their practice has existed for some time. Doctors, dentists, lawyers, accountants, and other

On a Side Note…

See another Wealth Planning Nexus Notes Quarterly article that may be of interest to you.

Living to 100… Is 100 the New 80?

Topic:
Wealth Planning, Living to 100
Excerpt:
It’s a common saying that there are two certainties in life, death and taxes. While we have a pretty good idea when we get taxed, which feels like all