How advanced investors use benchmarks
Written by Preet Banerjee
Friday, February 3rd, 2017
When it comes to benchmarks, there are plenty of them, and plenty of opinions on which ones are most appropriate. Let's explore some options and see how they can help you with monitoring your investment choices. But, before we do that, it's worth noting that index investors don't really have to worry too much about this stuff.
Indexers don't really need to benchmark
As an index investor, you're basically saying you've decided not to try and beat the benchmarks, but rather just track them (less the cost of investing). The reason this type of investing has become so popular is that underperforming the indexes by a small amount has historically been better than the average performance of everyone else (who try to beat the benchmarks). While there are winners and losers, in aggregate they end up underperforming the benchmarks by a larger margin. If you have a properly constructed portfolio where the asset allocation is suitable for you and your goals, and you're properly diversified across different indexes around the investing world, then as an index investor your only real focus is staying the course and adding money to your portfolio when you can.
But for the many investors who are actively trying to beat the market or markets, whether they're using actively managed funds or passively managed investments, benchmarks and benchmarking are concepts that will be tremendously useful in monitoring their strategies.
The market as a benchmark
If your portfolio only had Canadian stocks, then most people would suggest that the overall Canadian stock market should be your benchmark. This makes sense. If you've decided to hold only 5 stocks but the market contains 5,000 stocks, you're implicitly believing that these 5 stocks are going to do better on average than holding all 5,000 stocks. You can test this over time by comparing the performance of your portfolio against the market's overall return.
One of the most common benchmarks for Canadian stocks is the S&P/TSX Composite Index. Most portfolios of Canadian stocks can legitimately be compared against this benchmark. This could range from your own selection of individual Canadian stocks to managed funds (for example mutual funds and segregated funds) that invest only in Canadian stocks.
But sometimes the overall benchmark for Canadian stocks may not be the most appropriate benchmark for a 100% Canadian stock portfolio. (Yes, I know that sounds like an odd statement.) It has to do with your "opportunity set."
What's your opportunity set?
The appropriate benchmark you choose should ideally match your opportunity set if you want to understand how good you are at "beating the market."
What this means is that if you've constrained yourself to only picking small-cap Canadian stocks, a better benchmark for this portfolio would be the S&P/TSX SmallCap Index, since small-cap stocks tend to have different risk and return characteristics than the overall market for all Canadian stocks. This particular index matches the opportunity set you've chosen. (Again, because only small-cap stocks have the "opportunity" to be in your portfolio since this was the constraint you set.)
Now, this doesn't mean you should entirely dismiss the larger benchmark, either. While benchmarking your portfolio of small-cap Canadian stock holdings against a Canadian small-cap index will tell you how good you've been at picking small-cap Canadian stocks, you could also compare your portfolio against the larger, overall Canadian stock index to see if the decision to invest only in small-cap stocks was a good one or not.
Another example to drive home this subtle point is to look at someone who's added exposure to U.S. stocks to their portfolio. Let's say this portfolio consists of 80% Canadian stocks and 20% U.S. stocks. If you simply compare your portfolio's performance only against the Canadian stock index, you might get some clues as to whether adding U.S. exposure worked or not, but it won't tell you how well you did at picking the actual U.S. investments. You'd have to compare the 20% of your portfolio invested in the U.S. against a suitable U.S. stock market index to figure that out. It's possible that U.S. stocks in general had a strong year returning +15%, but the actual U.S. stocks you owned only returned +10%, thus underperforming by 5%. Imagine Canadian stocks were flat that same year. Simply by virtue of having exposure to the U.S., your portfolio did better, even though your actual U.S. investments did poorly compared to their benchmark.
One solution that can help is to create a custom benchmark for your portfolio. From our above example, where the portfolio is 80% Canadian stocks and 20% U.S. stocks, our benchmark would reflect this. You'd simply multiply the return of each benchmark for each asset class by its weight in your portfolio. In our case, with the S&P 500 being a popular benchmark for U.S. stocks, our custom benchmark would look like this:
(80% x S&P/TSX Composite) + (20% x S&P 500)
If the Canadian benchmark returned 10% for the year, and the U.S. benchmark returned 5%, then (80% x 10%) + (20% x 5%) = 9%.
We would also look at each individual asset class to make sure that overperformance in one asset class is not masking horrible underperformance in another.
As a final word, it's important not to make hasty judgments on your long-term investment portfolio based solely on short periods of performance measurements. By virtue of picking investments that are different than the benchmark indexes, you'd necessarily expect different performance patterns. As you start to look at performance over longer periods of time, this may indeed become cause for concern. But just remember, there's more than one way to benchmark a portfolio.