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.
All that and more in Episode 60 on the Wilson Wealth Management YouTube channel.
“What is an index benchmark?”
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?”
There are a few reasons why an index fund will not exactly match the index return.
Tracking Error
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.
For a little more information on index benchmarks, please read “Relevant Index Benchmarks”.
