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.
