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INVESTOR TOOLBOX: USING BENCHMARKS
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Fund Library Q&A
Your questions about financial planning, investments, and portfolio management answered by an industry expert



By Robyn K. Thompson  | Friday, July 10, 2015


Q – I have a portfolio of stocks and some bond funds for fixed-income exposure, in a split of about 60% stocks and 40% bonds. I can calculate my annual portfolio performance using my advisor’s account statements. But it just doesn’t seem to hold up when compared to the S&P/TSX Composite Index. I’ve been told that I’m using the wrong benchmark as a comparison. I thought stock indices like the S&P/TSX Composite or the S&P 500 Composite were pretty standard. Am I wrong? – Jon B., London, Ontario

A – A benchmark is an independent standard against which you can compare the performance of your portfolio. That sounds fairly simple in theory. In practice, there’s a bit more to it. And it all comes to down apples and oranges.

The old saying that an unfair comparison is like “comparing apples to oranges” is especially true when it comes to finding some way to determine whether your investment portfolio is performing “as it should be.” Now let’s note right here that a benchmark is not quite the same as a “target return.” If you’re aiming, say, for a 5% average annual compounded rate of return on your portfolio, that’s your target, or objective – it’s what you’d like your portfolio to return. Remember that this is an “average” annual return compounded over a longer time horizon. In some years, your return will be less than 5%, and in some years it will be more.

During those up and down calendar year periods, how do we know if our portfolio is still on track? That’s where a benchmark comes in. For example, if you invest only in large-capitalization Canadian stocks, you might use the S&P/TSX 60 Index of 60 Canadian large-cap blue-chip stocks as a benchmark against which to compare your portfolio’s performance. In other words, you’d expect your portfolio to perform at least as well as – or preferably better than – the “passive” index alternative for any given period.

When benchmarks go wrong

But things get a bit more challenging when we consider that most investment portfolios consist of more than just large-cap Canadian blue-chip stocks. There may be fixed-income investments as well as U.S. and other foreign stocks. Assets are typically weighted to reflect your risk tolerance and longer-term objectives. A typical portfolio that includes both stocks and bonds will not, by definition, perform like a portfolio consisting solely of stocks (e.g., a benchmark like the S&P/TSX 60 Index). So comparing the performance of a portfolio that includes different asset classes against a single broad stock index is likely to give you a distorted picture of investment expectations – you’ll appear to be consistently “underperforming” that benchmark, especially during a bull market phase.

A good benchmark has five essential characteristics.

1. It’s unambiguous in that the components are clearly specified.
2. It is appropriate or representative in that it is consistent with your portfolio objectives.
3. It must be measurable and be established frequently.
4. It must be current and based on marketable securities.
5. It must be investable in that it can be replicated and the components can be purchased separately.

Creating benchmark indices has become big business. For example, market data and credit rating company Standard & Poor’s now calculates about 700,000 indices globally, including some 200 Canadian indices, as well as the venerable Dow Jones Indices. Other major index providers include Morgan Stanley Capital International (MSCI) and FTSE (which also calculates the FTSE TMX Canada fixed income indices), which also calculate thousands of indices every day. As you might expect, choosing the right sort of benchmark index for your own portfolio has also become somewhat complicated. Many of these indices are publicly available and can be tracked daily. And many are also the basis for exchange-traded funds.

So the bottom line is that when measuring performance, be sure to compare apples to apples for a fair comparison. In other words, match your fixed income against an appropriate fixed income benchmark, Canadian equities against an appropriate Canadian equity benchmark, and so forth. If your portfolio’s fixed-income and equity weightings differ, say a 40%/60% split, you might consider creating a benchmark blended from appropriate fixed-income and equity indices using the same weightings as your portfolio. Portfolio managers often use this approach to get a more accurate performance comparison.

If you use a financial advisor, ask them to spell out which benchmarks they or their asset managers use as a yardstick to compare performance. All professional money managers use such benchmarks, and should be willing to tell you what they are. Robyn

Robyn Thompson, CFP, CIM, FCSI, is the founder of Castlemark Wealth Management, a boutique financial advisory firm specializing in wealth management for high net worth individuals and families. Contact her directly by phone at 647-352-5735, or by email at rthompson@castlemarkwealth.com for a confidential planning consultation. Follow Robyn on Twitter and Facebook.

Submit a question on investments, financial planning, or portfolio management. We cannot reply personally and cannot guarantee your question will be used.

Notes and Disclaimer

© 2015 by the Fund Library. All rights reserved. Reproduction in whole or in part by any means without prior written permission is prohibited.

The foregoing is for general information purposes only and is the opinion of the writer. No guarantee of investment performance is made or implied. It is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice. Please contact the author to discuss your particular circumstances.

 
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