By Scott Roark, MBA, PhD | October 25, 2019

Jim and Chris spent some time discussing benchmarking in a recent Q&A podcast episode. It may be helpful to get in writing some more of the important ideas around this critical aspect of investment management.

Measuring Portfolio Performance

It is critical that a benchmark is used, because without benchmarking there is no objective measure of portfolio performance.  In virtually no other area of life would you accept that – so why would an investor (or an advisor) not measure portfolio performance?  There are a few reasons, and none of them are very good from an investor’s perspective:

  • The performance of the portfolio is lagging an appropriate benchmark. This simply means that the investments are underperforming – that an investor is not doing as well as a benchmark.
  • The comparison of an investor’s portfolio with a benchmark will highlight the impact of an advisor’s fees on a portfolio’s returns. One of the uncomfortable truths of paying advisor fees (along with other fees) that are between 1-2% is that those fees are a direct drag on the performance of your portfolio.  In a world where you might expect a portfolio’s performance, without fees, to generate 5-6% per year, a 1% fee means that 15-20% of the gains you might otherwise have are gone.  And if you have 2% in combined fees, now you’re losing 30-40% of your potential returns over the long-term.
  • Using a benchmark might raise difficult and uncomfortable questions. Especially if the answers to those questions are found in reasons 1 and 2 above.  But there are other reasons a portfolio might lag a benchmark that aren’t as bad.  And an advisor should hopefully be willing to address those questions with a client who is interested.  Some other reasons a portfolio’s performance might be different than an appropriate benchmark is the fact that benchmarks are devoid of economic reality.  That is, the benchmarks typically do not include custody fees, taxes, trading fees, management fees, advisory fees and they assume frequent rebalancing and an otherwise static investment amount.  So if you are putting money in, or taking money out of your investment you will differ.  If you have to pay trading fees or taxes, your performance WILL be below the benchmark.

What Else to Consider

So when you benchmark, what is it that you are really trying to determine – or what do you really care about as an investor?  There should be things beyond just the return that your portfolio is earning.  While that “headline number” catches a great deal of attention, there are other considerations that should be addressed as well.  First among these is the risk of your individual portfolio compared to an appropriate benchmark.  If you think you are a conservative investor with a conservative portfolio, but find out that your standard deviation and your beta are more consistent with a moderately aggressive portfolio then you know you are taking on too much risk.  There has been a disconnect between what you wanted and what you have.

Another measure that is important in benchmarking is a correlation coefficient (also called “R-squared”).  Without getting too technical, this scaled measure shows how closely two items move together over time.  So having a high R-square (above 95) means that a portfolio is tracking its benchmark pretty closely.  If you have a low R-square (maybe 50-60), then that is an indication that you have two very different things.  If you are trying to mimic a conservative allocation fund, but your R-squared measure with a conservative benchmark is 50, then you are doing a poor job of matching.

At our firm, we track performance by comparing to benchmarks for our five convenience portfolios.  We have the following portfolios that vary by the risk associated with their asset allocations:  Conservative, Conservative Growth, Moderate, Moderately Aggressive, and Aggressive.  Each of these portfolios has different characteristics and different risks.  When a client chooses one of these portfolios, they should expect performance that closely matches the performance of the benchmark.  Of course, there will always be SOME differences, but understanding the differences is key for any investor.