by WWM | Sep 11, 2019 | Portfolio Review, Target Asset Allocation
You should compare your portfolio’s performance against predetermined target benchmarks.
We have already covered a few useful benchmarks.
Arbitrary returns, such as nil, the risk-free rate, or a required rate of return based on your needs.
Relevant publicly available indices that reflect the composition and risk of your actual portfolio. This is especially useful when passively investing in index funds. But there are still a few things to watch out for.
Benchmark performance, fees, and expenses against fund peers and category averages.
Better yet, combine some or all of the above benchmark options.
There is one other important benchmark that we have not yet covered.
Comparing your actual portfolio against your target asset allocation.
Target Asset Allocation
Your Investor Profile drives your target asset allocation.
It should factor in your personal circumstances, financial status, investment objectives, personal constraints, risk tolerance, and so on. As such, your target asset allocation will be unique to your own situation.
As your personal situation changes over time, your target allocation will shift as well. But changes should be made only when material events occur in your life (e.g., marriage, children, inheritance, career change) or when you move through phases of your life cycle. Alterations to one’s target asset allocation should not be an annual activity for most investors.
Actual Versus Target
Some experienced investors may compare the expected returns of their target asset allocation to the actual results. This can be done if you can assign expected returns to each asset class. Many investment companies, research firms, and professional organizations publish forecasts for major asset classes. However, these are far from guaranteed to occur.
Instead, compare your actual asset allocation against your intended allocation. It will not likely be the same.
The reason is that your portfolio will probably earn some income in the form of dividends or interest. You may also buy or sell investments from existing liquid assets. These will all impact your cash component.
As well, you will incur unrealized gains or losses on your investments. These changes will affect your actual allocation.
For example, you invest $10,000 on January 1. Your target asset allocation is 70% global equities and 30% in global bonds. You buy 100 shares of Vanguard Total World Stock Index ETF (VT) at $70 per share and 40 shares of Vanguard Total World Bond ETF (BNDW) at $75 per unit. At year end, you review your portfolio and find that the VT shares are worth $90 each and the BNDW shares at $65.
Based on changes in market prices, your portfolio is now valued at $11,600, ignoring any fund distributions. Although you did not buy or sell any shares or units during the year, your portfolio allocation now sits at 78% equities and 22% bonds. Suddenly, you are out of alignment with your planned allocation.
Good or Bad?
When comparing your actual portfolio performance against an index, peer, or arbitrary value, the higher the better.
But in comparing your portfolio against the target allocation, the less variance the better.
Ideally, you would like your actual portfolio to maintain its target ratio as long as possible. But this is not realistic. In creating a well-diversified target allocation, you may have 4-8 different asset classes and subclasses included. As the investments grow in number, it is pretty certain that your actual allocation will differ from the target yearly.
Also, because a well-diversified portfolio should see some assets increasing in value and others falling as they act as hedges against each other’s movements. That is a purpose of being well-diversified.
So your objective in this analysis is to monitor your portfolio and make sure that it stays within a certain range of your target asset allocation.
Target Range
Range?
Yes, range.
To the extent practical, you want to maintain a buy and hold investment strategy. But if you want to ensure a fixed ratio of 70% stocks and 30% bonds, then you will need to rebalance constantly.
In our example above, that might mean selling shares of VT and purchasing additional units of BNDW with the proceeds to rebalance. That works for now. But what about the next review? What if stocks have fallen in price and bonds have increased? You might find that your VT shares are only worth 50% of your total capital. Then you need to sell some BNDW and buy some more VT. And the next review, things may change again.
Not a formula for successful investing.
Instead, use ranges for your target allocations. Maybe you desire a 70-30 split between stocks and bonds. Fine, but create a comfort zone to prevent frequent adjustments. Especially for price changes due simply to normal asset volatility. Perhaps your target range can be 65-75% stocks and 25-35% bonds. Or 60-80% stocks and 20-40% bonds. Though this latter example may be a tad too wide.
That will give you some leeway during your reviews, thereby preventing continuous adjustments with the attendant transaction fees and taxes on capital gains.
The range you select should reflect your individual tastes. Your investor profile, personal risk tolerance, and ongoing review experience will play a large part in how wide the ranges are.
It should also reflect the volatility of the underlying investments. A blue chip equity fund should be less volatile than a small cap software fund. If you want 20% of your assets allocated to each fund, perhaps your target range for the blue chip is 15-25%, whereas the more volatile small cap could be 10-30%.
by WWM | Sep 4, 2019 | Portfolio Review
If you create a portfolio of individual stocks and bonds, it may be unique to you.
Creating a benchmark takes a little work.
You likely will want to compare your portfolio performance against a static figure. Zero nominal return, zero real return, risk-free return, historic return, expected return, etc.
You can usually find a relevant index (or three) to create a relevant portfolio benchmark. Perhaps a mix of equities, fixed income, and cash indices that reflect your target asset allocation.
All good. But do not stop there in comparing your portfolio performance.
Here, we will assume that you passively invest in low-cost, index, mutual or exchange traded funds. A great way to assess fund performance is to compare results against the fund’s peers.
Compare Performance with Relevant Investment Style
Review your portfolio of funds against other funds of a similar style.
Your funds will follow a specific style. For example: U.S. large growth, pacific ex-Japan, European financial.
Each category will include both actively managed and passive index funds. So you can readily determine if active management for an investment style can outperform passive.
You can assess your fund performance against the average return for that category. Data is usually available for many categories. This allows you to see how your fund performs relative to the average fund in the class.
Obviously you want to invest in a fund that is above the average result. If your fund is not, consider the reasons why and take any necessary remedial action.
You can also compare against the top performers. Often, category leaders in a class are disclosed. Or you may find data that shows where your fund ranks in the entire category. Often disclosed by either quartile or percentage rank.
Depending on the fund and investment category, there may be more or less data available in public forums. You may need to look at multiple sources to get enough data.
It is important to look at longer term performance comparatives. One year is usually too short to properly assess.
In the short run, a fund manager may get lucky (or unlucky). The timing of transactions may cause higher or lower relative returns. Perhaps one manager is better in bull markets, another in bear, so you want to see their relative performance in both up and down markets. Maybe one fund is small and can invest significant assets into niche market segments. As that fund grows in size, its investment opportunities may diminish. Very large funds often become the market. You may see style drift that renders apples to apples comparisons useless. There are so many reasons why short term results may not be indicative of relative future performance.
Better to use at least 3 year data, or, if available, 5, 10, or 15 year performance comparatives. The longer the comparison, the better. Of course, then you also must ensure that the fund manager is the same for the entire period. A new manager may alter comparisons over time.
Compare Expenses, Not Just Returns
While net performance factors in expenses and fees, it is prudent to explicitly compare those to peers separately.
Why?
Expenses and fees are a good indicator as to future performance. The more costs your fund incurs, the greater the likelihood that it will under-perform over time.
Remember, with expenses and fees, lower is better.
Compare Risk Factors
Risk assessments may be a little advanced for now. But we will cover some of the key figures (e.g., Sharpe ratio, standard deviation, alpha) down the road.
Risk analysis is important as you always want to compare apples to apples.
Investors expect higher returns for incurring greater risk. The more risk, the higher return demanded.
The better your credit rating, the less the interest rate your bank charges on car loans or home mortgages. That is why, in general, cash offers lower returns than fixed income and fixed income less than equity. Of course, within a specific asset subclass, you may see some variation.
Perhaps you are comparing two Canadian equity funds. One fund holds nothing but large cap, “blue chip” companies, that pay healthy dividends. The other fund owns nothing but small cap, thinly traded mining companies. Both are Canadian equity funds, but with much different risk profiles.
If your portfolio has significantly higher risk than the category average or another fund, you will expect to earn higher returns. By comparing your portfolio’s risk against its peers (or markets), you can determine if your returns are appropriate. This is essentially the Sharpe or Treynor ratios.
And yes, risk can differ between funds even in the same asset subclass category. So you definitely want to compare the risk of your investments to its peer group.
by WWM | Aug 28, 2019 | Portfolio Review
Index benchmarks for passive investment management are an ideal fit.
And quite easy to implement.
After all, with passive investing you are simply trying to replicate the market (as represented by the relevant index). So it is simple to find an index for comparative purposes.
But there are a few things to remember when benchmarking under a passive approach.
Index Funds Under-perform Benchmark Indices
No matter what passively managed index fund you invest in, mutual or exchange traded, it should under-perform it’s relevant benchmark index.
The goal is to try to get as close as possible to the benchmark.
Here are two reasons why an index fund will not exactly match the benchmark index.
Tracking Error
When index funds attempt to replicate an index, tracking error between the two typically occurs.
There are usually two reasons for tracking error in index funds.
How a fund is constructed to replicate the index causes tracking error.
Also, timing and pricing of transactions in adjusting the fund to reflect changes in the underlying index creates errors.
Tracking errors can go both ways. At times, the timing of transactions and the method of index replication may cause the error to result in a positive variance.
Your goal is to find funds with minimal tracking error. That will ensure you come as close as is possible to matching the index’s returns.
Fund Fees and Expenses
There will be certain costs associated with managing any fund. Fees that an actual benchmark index does not incur.
Management fees in index funds should be de minimis, if not zero. If there are management fees charged in a passive index fund, think twice about investing. And never pay a sales commission (a.k.a., load).
But there will be some operating and administrative expenses. Trading commissions, shareholder communication, regulatory dealings, portfolio maintenance, are a few such costs.
Even with index funds, there can be significant differences in fees and expenses. Pay attention to fund costs. Minimize, minimize, minimize.
Even if you are investing in an index fund, you will not exactly match the index’s return.
Your objective though is to get as close as possible.
by WWM | Aug 21, 2019 | Portfolio Review
When reviewing your investment portfolio, you should use an appropriate benchmark to compare performance.
Investment benchmarks should try and mirror your portfolio holdings.
Not the exact individual investments. But the benchmark should reflect the portfolio’s asset classes (and subclasses), investment styles, and the overall risk level of the portfolio. It should also match your target asset allocation.
Using publicly available indices as benchmarks is a simple, but effective, way of achieving this goal.
Index Benchmarks
Index benchmarks are suitable for any type of portfolio.
There are numerous indices available for probably every variation of asset classes and subclasses. Per the Index Industry Association, there were approximately 3.7 million indices offered in 2018. You should easily find one or more indices that come close to reflecting your portfolio composition. This facilitates better apples to apples comparisons.
Index performance data is often calculated daily, so it is easy to determine comparatives.
Find Indices That Match Your Portfolio
With the wide variety of indices, find ones that best match your assets.
For example, a general U.S. equity portfolio might be quite similar in composition and risk to the Standard & Poor’s (S&P) 500 index. However, a portfolio heavily invested in Japan might be better off using the Nikkei 225 as a benchmark. And if you have a global bank-centric portfolio, the Dow Jones Banks Titans 30 Index might be the most relevant.
The same thought process applies to fixed income. Government bonds may have different risk-return profiles than corporate bonds. Risk and return may also vary between countries. Junk bonds will have different profiles than AAA rated bonds. And there will be differences between short, medium, and long-term bonds.
J.P. Morgan has a number of bond indices. These include: J.P. Morgan Global Aggregate Bond Index; J.P. Morgan Emerging Market Bond Index; J.P. Morgan Government Bond Index. Again, whether it be through J.P Morgan or another index, you have many options in selecting fixed income indices to meet your needs.
Even for non-core asset classes or investment strategies, you can find ready-made indices. For example, the S&P Dow Jones Indices, include such indices as: S&P Real Assets; DJ Commodities; DJCI Lean Hogs; Dividend Aristocrats; S&P Pan Africa Shariah; S&P 500 Catholic Values: S&P Eurozone Low Volatility; S&P Target Date 2045.
As you can see, with 3.7 million indices out there, you should be able to find those that meet your needs.
You May Need More Than One
Yes, there are indices that cover different investment strategies and multi-asset portfolios. But you may not find one index that completely matches your entire portfolio.
That is not a problem.
Simply create a composite benchmark that reflects your personal asset allocation.
For example, let us take a simple portfolio. Say 5% U.S. dollars, 35% U.S. bonds of various maturities, and 60% global large-capitalized (cap) equities. For the bonds, the S&P U.S. Aggregate Bond Index might be suitable. And for the equities, the S&P Global 100 represents 100 large capitalized companies from around the globe. Or, for a wider scope, the S&P Global 1200 covers about 70% of global market capitalization.
As best you can, compare apples to apples when comparing your portfolio to the benchmark.
If you have a large percentage of Swiss equities, the S&P Global 100 might not be best. Instead, a Swiss Market Index (SMI) may be more appropriate.
You may also want to drill down into your investment style, if it is relevant.
Perhaps your Swiss equities are made up of large-cap companies. Then the basic SMI works well. But if you have invested in small or mid-cap companies, an index of large-cap companies may not be optimal. You may consider using the Swiss Performance Index (SPI) Extra. This index tracks Swiss small and mid-cap equities outside the SMI.
There are a multitude of indices available. Try to find ones that match your asset groupings as closely as possible.
Then Allocate in the Proper Percentage
Finding the best indices is one part of the equation.
Equally important is to match the weightings of your target asset allocation with the relevant benchmark indices.
If Swiss small and mid-cap equities make up 5% of your portfolio, then the SPI Extra should be weighted 5%.
If global large-cap equities account for 60% of your investments, then weight the S&P Global 100 index at 60%.
A fairly simple concept.
Next, some thoughts on benchmark issues in the context of passive investing.
by WWM | Aug 15, 2019 | Portfolio Review
Investors can review their investment portfolios against a wide variety of ready made financial benchmarks.
Appropriate portfolio benchmarks should reflect the actual portfolio as closely as possible. An apples to apples comparison.
The selected benchmark should also be easy to calculate for comparative purposes. If you cannot get access to timely data, even the best of benchmarks will be of little practical value.
What are a few simple benchmarks, commonly used by investors?
Positive Nominal Return
Think of this as a zero return benchmark.
The goal is to obtain a positive nominal return for the period. Simple, very easy to track.
Probably best for low risk individuals who invest primarily in cash equivalents or low risk fixed income assets. But, as we shall see below, not that great a benchmark in the real world.
Positive Real Return
Real return reflects the impact of inflation on your performance. Nominal return does not.
To calculate real return you must subtract the inflation rate from the nominal rate of return. Inflation data is easily attainable, so this is a simple calculation to monitor.
Perhaps you invest $1000. At the end of one year you receive $1100. The nominal return on the investment is $100 or 10%. Not bad against a nominal benchmark return of 0%.
But what if inflation for the year was 15%?
In rough terms, let us say that your $1000 buys a specific basket of goods and services on January 1. That same basket at 15% inflation will cost $1150 on December 31.
Although your 10% nominal return sounds good, with 15% inflation your purchasing power eroded over the course of the year. Your real rate of return is actually -5%.
You would have been better off not investing the money, instead spending the money on goods and services. That is the impact of inflation. For a real world example, look at Venezuela. How much return would you require to keep pace with inflation? 100,000%? 1,000,000%? 10,000,000%?
A positive real returns benchmark is probably best for low risk investors whose portfolios are heavy on cash equivalents and fixed income. Given the potentially debilitating effect of inflation on interest and dividend income, I suggest using real returns for benchmarks over nominal ones.
Note that a problem with inflation is that official rates may not always parallel an individual’s own cost of living changes. Inflation is usually calculated based on a basket of goods and services. If your own expenses differ in any significance, official inflation may differ from your personal experience. Similarly, official inflation for (say) Canada may not be identical to someone living in Cape Breton, Vancouver, or Yellowknife. Keep that in mind if choosing inflation as your benchmark.
Risk-Free Rate of Return
A good benchmark in general terms. And very easy to determine.
The risk-free rate is the return you would earn on an investment with no risk. Assets that are fully backed by federal government guarantees are the closest thing to risk-less, although this becomes less true as governments get into serious debt problems. U.S. Treasury Bills is one such risk-free asset. Venezuelan debt, likely not.
The advantage of this benchmark is that it reflects your portfolio return if it carried no risk. For example, 100% invested in Treasury Bills. But a diversified portfolio has some level of risk. In the risk-return relationship, the greater the risk assumed, the higher the demanded return by investors. As well, within a specific asset class, risk can vary significantly.
Unless you are 100% in risk-free assets, you should expect greater returns from your portfolio. By setting a benchmark for assets with no risk, you can easily see if your riskier portfolio generates extra returns to account for the higher risk.
The risk-free rate of return can be used as a benchmark for any portfolio. The lower the risk of the portfolio, the more relevant it will be though.
The higher the portfolio risk, the less relevant. This is because you expect a higher risk portfolio to achieve greater returns over time than a risk-free asset.
But how much greater the return is appropriate? That is the tricky question.
If the risk-free rate is 4%, should a high risk portfolio be expected to return 10%? 15%? 20%? I have no idea. The higher the portfolio risk, the more it becomes an apples to oranges situation when comparing a higher risk portfolio to the risk-free rate.
That is a problem with using 0% or the risk-free rates as benchmarks. In assuming some portfolio risk, you expect commensurate returns. However, what that higher level is depends on a few factors. Your risk tolerance, possible returns from other assets, opportunity costs, portfolio fees and expenses, tax rates on different gains, etc. The “commensurate” level will differ between individuals, as well as within a person as their circumstances change.
Arbitrary Nominal or Real Returns
A benchmark of 0%, in either real or nominal terms, may not be an appropriate number.
One reason is that your portfolio should be seeking higher returns than 0% anyway. So a null return might not make any sense (apples to oranges).
A second is that even if you beat the benchmark consistently (say averaging 1% per annum), you may not generate enough wealth over time to retire comfortably.
Because of this, some investors choose arbitrary benchmarks. Either in nominal or real terms.
Often there is some rationale behind the number. 10% is always a nice round number. Maybe equities averaged 12% over the last decade, so that seems like a reasonable target. There are many reasons for arriving at a benchmark. Some make more sense than others.
For example, you intend to invest $12,500 at the start of each year for 25 years and want to amass $1 million. To do so, you need to earn over 8% per annum each year. So that may be a relevant return target.
Or perhaps you rely on historic data or future forecasts. Over the last 40 years, Canadian equities have returned approximately 8.5% annually. However, many financial professionals forecast around 6.0% per annum in the near future. If you decide your Canadian equity benchmark should be a 15% return, you may be making an error. And very disappointed if your actual return does 10%, even though it will be higher than both historic and forecast returns.
Arbitrary return benchmarks may be suitable for balanced (mix of cash, fixed income, and equities), some fixed income, and equity. The challenge is in choosing a return figure that makes sense.
Summary
These benchmarks are used by many investors.
They are easy to identify and performance data is plentiful. Very important when choosing a benchmark. The best benchmarks in the world become meaningless if you cannot get the data.
These common benchmarks give some good general information.
They may show if your portfolio achieved positive returns in either nominal or real terms.
Or if it outperforms a static number chosen based on personal reasons. Perhaps the risk-free rate. Perhaps a return required to meet specific goals.
But these benchmarks often make apples to apples comparisons difficult. They may not adequately reflect the composition and risk of your own portfolio. And if the informational value is weak, it makes the use of that benchmark less relevant.
While these benchmarks are useful in a general sense, I suggest you consider other options.
We will look at more practical benchmarks next time.