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.
How do you build an efficient and effective investment portfolio? What type of investment accounts to open? Are there other methods to build wealth over time outside your own accounts? What is the “Lump Sum versus Dollar Cost Averaging” debate?
To date, we have covered investor profiles and how they drive the target asset allocation. We have also reviewed the asset classes, different types of investment options, and whether to actively manage your assets or not. We can now take all that knowledge and begin to construct an investment portfolio.
In Episode 43, we consider the following questions:
“What type of investment accounts should I open and where?”
We discuss where you should maintain your investment accounts.
With your current financial institution, where you have your chequing account? Should you consider a speciality or independent brokerage house? Or with a mutual fund company?
“What about tax-efficient accounts?”
We look at the differences between taxable and tax-efficient investment accounts.
For most investors, annual and cumulative contribution limits are often high enough that taxable accounts are not needed. But that will vary between jurisdictions.
“Will I need a margin account?”
There are pros and cons to setting up margin accounts versus cash accounts.
A margin account allows you to leverage your portfolio. In an up market, leverage can be useful as it boosts returns. However, in a down market, or where the investment in question declines in value, that can create problems.
“What other investment options may exist?”
Often, employers provide employee pension plans. These may be defined benefit, where upon retirement you receive predetermined periodic payments from the pension plan. Or defined contribution, where the employer (and perhaps employee, as well) makes periodic monetary contributions into the plan. Upon retirement, the employee receives the value of the total contributions and investment return growth.
Employers may offer Employee Stock Purchase Plans (ESPP). Or stock options to key employees.
You may be able to invest directly with public companies, with no transaction costs. Direct Stock Purchase Plans (DSPP), convertible assets, warrants, and options, are a few examples.
Finally, there are often Dividend Reinvestment Plans (DRIP) for investments you acquire. The DRIPs allow investors to automatically reinvest any distributions (e.g., dividends) into the investment, rather than receiving cash.
You have defined a target asset allocation. How should you now build your investment portfolio? By investing in non-diversified, individual assets? Such as common shares of Apple or Tesla. Or is it wiser to invest via well-diversified investment products? Such as mutual or exchange traded funds.
This is a “build your own” portfolio approach. You analyze potential investments across various asset classes and subclasses. Then invest in securities deemed “best in class” to fill out your target asset allocation.
In theory, as you only own the “best” investments in each class, maybe shares of Apple, Google, or Netflix for equities, you should create a strong portfolio. One that outperforms your benchmarks.
Whereas if you bought a S&P 500 index fund, you purchased 500 different companies, whether you want them or not. Great to hold Facebook, Apple, Netflix, and Google in the fund. But you also “own” Norwegian Cruise Lines, Carnival, and United Airlines. Companies whose shares plummeted in 2020 due to COVID.
By owning the “FANG” stocks and avoiding the cruise lines, you would have beat the index return.
Makes a lot of intuitive sense. And the main marketing tool from active asset managers.
This is a doable approach if you have the critical mass of capital to diversify across your target asset allocation. If you are a High Net-Worth Investor, a “build your own” portfolio can make sense.
It may also be a good approach for active traders. Who create non-diversified portfolios and like to jump in and out of specific positions. Or for those who like to tactically invest or engage in market timing. Utilizing a portfolio of individual securities may be a positive for these investors.
Okay, that sounds quite easy. Investing in individual securities is definitely the way to invest.
But it is not that easy in practice.
“What are the potential problems with investing in individual securities?”
While doable, it may not be practical for many investors.
Retail investors may lack the critical mass of capital to manage this approach effectively and efficiently. Though, often smaller investors can find cost effective ways to help acquire common shares. Dividend Reinvestment Plans tend to be very useful.
Can you manage investment fees? If you need a minimum of (say) 30 equities, 15 bonds, and some cash, transaction costs can add up over time as you build or adjust positions. It is much more cost effective to invest $100,000 at a time in an investment, as opposed to $300.
You may also trigger taxable events in buying and selling individual securities.
Can you consistently pick the winners? There are a lot of asset classes and subclasses. With a myriad of individual investments in each. How do you find the “best”? An issue we will cover in future episodes.
Can you manage the opportunity cost? The time required to monitor and amend the portfolio. You cannot simply buy a stock and forget about it. Quality changes over time. Better investments may emerge. If you have a portfolio of 50 assets spread globally, that may require significant time. Do you have the spare time to deal with the portfolio? Or hire someone who does?
Can your properly diversify your portfolio with 50 assets? Investment theory says yes, but you need to do a good job combining asset correlations to create an optimal portfolio. The less securities, the more challenging it will be.
All of these are potential disadvantages in individual securities. But the difficulty in optimally diversifying may be the biggest negative. The greater the number of investments required to diversify is what causes problems in the other areas. With investment expenses, having to consistently find winning investments, and the ongoing time required to manage the portfolio.
What are open-end and closed-end mutual funds? How are they similar? How do they differ?
What about exchange traded funds (ETFs)? How do they compare to open and closed-end mutual funds?
And hedge funds? Is that something retail investors typically use?
If you want additional detail on these different investments, please read “Investment Funds”.
“What are some of the pros and cons of investing via funds?”
Unsurprisingly, many of the potential disadvantages associated with individual securities are positives in investment funds. Investors do not need much money to invest. Well-diversified products. Many are low-cost for investors. Actively managed funds are run by investment professionals. Investor portfolios will have very few investments versus an individual approach. Much less time commitment to monitor.
And the advantages of associated with individual assets tend to be potential concerns with funds. You may not own exactly the securities you want. If you passively invest, you will own the entire index. If you invest in actively managed funds, there may be some fund holdings you do not like.
This episode provides more of a high level comparison with the funds available for investors. We will dig much deeper into investment funds in upcoming episodes. Especially, the potential advantages and disadvantages of open-end mutual funds and ETFs versus individual securities. And in comparing mutual funds against ETFs as investment vehicles.