Investors should review investment performance against peer results. How do your individual investments compare to other available assets in the same asset class? And with similar characteristics.
In our last episode, we wanted to compare results versus relevant index benchmarks. An objective comparison against the standard. But some individual funds or assets are relatively better or worse than the standard index. Do you own “best in class” holdings? Or, are your investments languishing in the bottom of their asset category?
With investment funds, mutual or exchange traded, the peers are other funds that follow the same investment style or category. As such, they should have similar risk-return profiles as your fund.
For example, US large cap equities will differ in risk and expected return from small cap Emerging Market stocks. It may not even make sense to compare two US large cap equity funds. If one follows a value strategy and the other a growth approach. And it definitely does not make sense to compare Canadian High Yield Bonds with Japanese equities.
It is all about “apples to apples” comparisons. Find funds that are a good match when assessing.
“What is is ‘true peer’?”
A true peer makes your analysis even more useful.
If you own a fund with $100 million in assets, it may not be best compare it to one with $10 billion. The smaller fund may be more nimble and be able to invest in many more companies. The larger fund may have economies of scale, resulting in lower investor costs.
Even within the proper asset category or style, you still want to find funds that are comparable in structure.
“What are the keys to comparing peer performance?”
You can assess many different fund traits and statistics. Three key review points are performance, expenses, and risk.
Performance is what it is all about. You want to grow your wealth. So you want an investment that does well. Compared to simple benchmarks, such as inflation or risk-free rates of return. Versus its index benchmark. And to its peers.
Fund expenses are reflected in net performance. But you should also consider them separately. Fund costs are a strong predictor of future success. So you want to compare them with peers to ensure you own a low-cost product.
Risk is also important to assess separately. Even with similar funds, there may be differences in risk levels. You should look at ratios, such as Sharpe and Sortino, to assess how efficient your fund is in using risk to generate relative return. Then compare that with peers.
“Can individual stocks and bonds have peers?”
Yes. And some of the same review principles for funds apply to non-diversified investments.
For example, you want to find true peers to compare results. Toyota versus Ford. Not Google versus Nippon Steel. Or a value stock, such as Banco Santander, versus a growth stock, like Roku.
There are other return statistics. Return on Equity, Return on Assets, Return on Investment. You may want to compare Price/Book, Price/Earnings, and Earnings per Share. And even more nuanced, such as Debt/Equity, Receivables Days Outstanding, and Quick ratios.
“What about asset specific risks?”
Non-diversified assets, such as individual stocks and bonds, have nonsystematic risks (stock specific) to assess.
Did the company just hire the next Ken Lay to run its operations? Or is Warren Buffett at the helm? What are the legal risks that could derail the company’s progress? Are there patents expiring that will impact future revenues? And so on.
When comparing individual companies, as opposed to a fund with many holdings, you must perform deeper dives when comparing the future fortunes of your investment and peers.
Whereas, with well-diversified investment funds, your analysis is more on systematic risk factors.
When evaluating investment portfolio performance, it is useful to compare actual results to relevant benchmarks. In this episode, we consider index benchmarks and how they can be used in portfolio reviews. Especially for passive investors.
It is simply using an index as a benchmark to assess your portfolio’s performance.
Using an index to compare actual performance may provide better information than using one of the common benchmarks discussed in Episode 59. Zero return, real return, risk-free rate of return, and arbitrary returns.
All may be useful. But it is more apples and oranges than apples to apples.
Does it make sense to compare your Swiss equity fund to the inflation rate in Canada? Yes, you want to return more than the inflation rate. So it gives some feedback there. But is there not a better comparable for your investment? Possibly the Swiss Market Index (SMI) or the SMI Expanded.
Apples to apples. That is always a key to successful portfolio reviews.
“Is it easy to find an index to use as a benchmark?”
If you passively invest, you likely own an index fund. Finding a benchmark then, is relatively easy.
The appropriate index may be in the name of the fund itself.
For example, iShares Canadian Select Dividend Index ETF (XDV). Its fact sheet says the ETF “seeks to provide long-term capital growth by replicating the performance of the Dow Jones Canada Select Dividend Index, net of expenses.”
If not, the fund fact sheet will disclose the index the fund seeks to replicate.
Vanguard Small-Cap Value Index (VBR) “seeks to track the performance of the CRSP US Small Cap Value Index.”
Whether it is stated in the name or fact sheet, it is usually easy to determine the optimal index for comparison.
But even if you have to seek out a benchmark, there are over 3 million available. Covering every asset class and subclass one can think of. Whether you are investing in mega cap US companies (S&P 500) or US high-yield bonds (Markit iBoxx USD Liquid High Yield Total Return Index), there will be an index to use.
“Will one index cover my entire portfolio?”
Not usually. Typically, investors will choose indices for each asset class or subclass. Then weight individual indices based on the initial portfolio target asset allocation.
You want to select the benchmarks and weightings in advance. Part of the review process is how the overall asset allocation has deviated over time from the target. And its impact on overall risk and return.
“Why does my index fund always underperform versus the actual index, as a benchmark?”
How the fund is replicated will play a part. Full versus partial versus synthetic. Without an exact match, there may be minor return variations.
Timing of trades can also cause actual returns to deviate and impact tracking error. A full replication should minimize tracking error. However, the more holdings in an index, the more trading needs to be done to ensure all holdings are in the fund. Small timing errors can create price fluctuations and impact returns.
Fund Costs
Indices are cost free. No trading fees. No shareholder communications to issue. No financial statements to prepare. No marketing of the fund. And so on.
The higher a fund’s costs, the greater the deviation from the index return.
You created an investment portfolio. Next, you want to review actual performance against predetermined benchmarks. What is a portfolio benchmark? What common benchmarks are used by investors to assess portfolio results?
A benchmark is simply something than can be used to compare actual performance. Of an investment. Or the portfolio as a whole.
The more relevant to your investments, the better the comparability. To the extent possible, you should look for “apples to apples” comparisons that reflect your holdings.
“What are some common benchmarks?”
There are a few very simple benchmarks that many investors use.
Zero Return
Any return above 0% is a positive against this benchmark. Useful, in that investors tend to not want to lose money on their portfolios. Regardless of the type of assets or level of risk.
Real Return
If your portfolio earns 2%, that is good versus a zero return benchmark. But what if inflation was 3%? In purchasing power, your 2% actually lost money. Many investors factor in inflation and assess results against the real return.
Given economic forecasts for 2022 and the near future, real return benchmarks may become popular.
Risk-Free Return
Most investment portfolios assume some level of risk. Many investors like to compare their portfolio against a riskless investment. The view being that a (even low-risk) risky portfolio should outperform a no-risk one.
Currently, short-term US or Canadian Treasury bills best reflect a risk-free rate of return.
Arbitrary Return
This return can be plucked out of the air. It can be nominal or real.
For example, your current capital and funding plans for the next 20 years require a nominal annual return of 6% to amass $2 million at retirement. Perhaps you wish to annually earn at least the inflation rate plus 3%. Or just beat your brother.
There could be a logical reason for the desired return objective. Or not.
“Are these ‘apples to apples’ benchmarks?”
If you are invested in nothing but Guaranteed Investment Certificates or other extremely low-risk investments, possibly.
But more likely, these are used as a ‘sanity check’. Simple, intuitive, easy to find. Then they are combined with other benchmarks that are more specific to your actual target asset allocation and investments.
We will look at more relevant portfolio specific benchmarks in the next episode.
Buy and Hold means holding an asset through your financial objective’s time horizon. But that does not mean Buy and Forget. Periodically review your overall portfolio and individual holdings. Ensure they remain best in class, meet your needs, and fit within your Investor Profile and Target Asset Allocation. What factors impact portfolio review frequency?
“How does portfolio risk impact review frequency?”
A relatively low risk portfolio may be reviewed less often than one with higher investment risk.
And that reflects both the type of asset and the level of diversification.
A low risk portfolio with one 5-year term deposit needs less a rigorous review than one with a variety of small cap, emerging market equities.
As well, investing in a broad index fund, with many holdings across different sectors and market caps, may manage overall risk better than if you created your own portfolio out of shares in Google, Amazon, Facebook.
“How do general economic and market conditions impact reviews?”
If inflation causes an increase in the prime lending rate, all borrowers will face interest rate hikes. The lower credit rating will be hit hardest, but even high quality borrowers will have to pay higher costs.
If a war breaks out where you live, manage a business, or invest, you will be affected.
The greater the probability that your investments will be impacted by systematic risks, the shorter the time span between reviews. Or, when you see a systematic risk arising, that may trigger a review.
The purpose of creating a well-diversified portfolio helps cope with systematic risk. If Canada experiences bad economic times, that may be buffered by also holding investments in Australia and Germany. If the equity markets go into a bear market, owning some fixed income (at a low to negative correlation coefficient), may provide some portfolio protection.
If your portfolio is not well-diversified, it is more at risk of systematic risk problems.
“Does my personality affect periodicity of reviews?”
Yes.
Some investors are more risk averse than others. Low-risk investors will often prefer a safer investment portfolio. That should mean less review time. However, their personality may be such that they will want quarterly or semi-annual reviews, regardless of the portfolio risk.
Conversely, some investors should be reviewing their portfolios (perhaps) quarterly. But their personality causes them to review every few years, when intending to sell something or the world is on fire.
As well, some people are very detail focused and some are quite relaxed. The detail oriented investor will likely want more frequent reviews (and spreadsheets with adjusted cost base, unrealized gains, yields, and such).
“Anything else that I need to consider?”
Material change.
Material changes are events that cause you to alter your decision-making.
You are single, living the good life. Not a care in the world. How you manage your life is a certain way. Then you get married and what was fine two years ago has now changed. Maybe vacation decisions went from a golf vacation with the gang or a trip to Ibiza to now choosing between the Louvre in Paris versus Tuscan wine tours.
Then, you decide to have a baby. Suddenly, you are googling “life insurance.”
Similar if you lose your job, get a promotion, have an accident, etc. Things that change your outlook and decisions.
With investments, material change is similar.
Much less of an issue with well-diversified portfolios. More an issue with less diversified investments, that are exposed to nonsystematic risks. Risks that are specific to that asset.
For example, you researched junior mining companies and found an excellent company. You invest. But three years later, management starts taking shortcuts in their operations. The company is now being sued for poor reclamation practices and environmental damage. Do you continue holding because – darn it – your strategy is to Buy and Hold? Or do you take that material information and revise your assessment based on real-time knowledge?
If you are not prepared to reassess investments in light of new information, perhaps you still hold shares in Enron, Kodak, Blockbuster, and horse and buggy companies.
But it should be significant information. Otherwise, you end up trading based on market noise and non-material events. It can take some skill and experience to separate out the material from non-material information. And yet another advantage to focusing on well-diversified investment products over individual stocks, bonds, etc. Much less concern in tracking individual assets, as the overall diversified portfolio helps to manage those nonsystematic risks.
In previous episodes, the emphasis was on investing in well-diversified investment products when employing a Buy and Hold strategy. Does Buy and Hold also work with non-diversified assets, such as individual stocks or bonds?
In this context, we are talking mainly about individual stocks and bonds. As well as other assets that may experience nonsystematic risk features and can be bought on an individual basis. A painting, home, stock option.
For example, a fund that invests solely in gold bullion may not be well-diversified. But investors tend to purchase gold as a niche investment to assist in diversifying the overall portfolio. So they are unconcerned about its lack of diversity.
Even broader stock or bond funds may not be well-diversified. Review the number of holdings in total, as well as the overall asset percentage of the top 10 holdings for too much concentration in limited holdings. Geography, capitalization and sector can also impact fund diversification. With bond funds, variables such as effective duration, credit quality, currency, geography, and issuer type can affect overall diversification.
But for these purposes, we will speak primarily about individual stocks and bonds, such as Coca-Cola or Google shares.
“Is it possible to build a well-diversified investment portfolio with individual assets?”
Yes.
However, you probably need a critical mass of investment capital to properly diversification.
Maybe you need 30-50 stocks. Some exposure to Canada. Also, the global markets. Do you want to diversify amongst small, medium, and large cap companies? Or through different industries and sectors? The more portfolio diversification you seek, the more holdings you need. And that requires capital to spread out your wealth.
Then, factor in additional asset classes such as fixed income. The number of portfolio holdings keeps growing.
So, yes, possible. Just takes time, energy, and capital. Much more effective and efficient to simply buy a ready-made fund.
I would note that most people create non-diversified portfolios. They hold 6-10 “fantastic” stocks and are fine in doing so. Perhaps they do well, perhaps not. If they invested in Amazon, Google, Apple, Facebook, Netflix, and Tesla, they will have done wonderfully versus the market.
The issue here is more what happens to the portfolio if Teslas begin to catch fire. Or the US and Australian governments crack down on Facebook. Or the EU hammers Google for its practices. Is there a company being created today that will cause Netflix to become the next Blockbuster? And so on.
That is the purpose of diversification. Spreading out the stock specific risk. And hedging your bets.
“How will my investment costs be impacted under this approach?”
The more investments you own, the greater the investment costs.
Not management fees to a fund company. But transaction fees when you buy and sell holdings. Perhaps tax when you sell and trigger a capital gain. Opportunity cost in spending time to monitor and maintain a portfolio with 30-50 stocks. Then add in bonds and any other asset classes and that is a fair amount of work.
“This will work well if I invest in highest-quality, ‘buy and forget’, holdings, right?”
Yes, you do want to invest in high-quality stocks and bonds.
But what is high-quality? An investment that is quality today, may not be quality tomorrow. And what is quality tomorrow, may not even exist today.
Not too long ago, companies like GM, GE, Kodak, Sears, etc., were household names and popular brands. With excellent stock. Today, they are all gone from their days of fame.
In their place, we now have Google, Tesla, Facebook, Netflix, etc. Companies that have really only been around for the last 20 or so years.
Kodak joined the Dow 30 in 1930 and departed in 2004. Before declaring bankruptcy in 2012.
Will Google, Amazon, Apple, Tesla, Nike, Netflix, and Facebook, all last that long? Or will there be new companies emerge that, as Apple did to Kodak and Netflix did to Blockbuster, knock off these high-quality companies?
Buy and Hold does not mean Buy and Forget. You need to monitor your portfolio and ensure it invests in quality holdings.
Diversified investment funds help achieve this. But when trading individual stocks and bonds, you need to constantly review and adjust your portfolio. This may results in hard costs (transaction fees, tax). It will definitely result in added time and energy to review your portfolio. If you have the free-time, interest, and knowledge, great. But for most investors working jobs in non-investment areas, sacrificing time to study investments becomes onerous.
Why not just stick to a well-diversified, low-cost fund instead?