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Portfolio Strategies

Benchmarking: The Art of the Science

There can be a serious disconnect between investors and the indexes they reference—which can lead to a great deal of benchmarking confusion.

by Craig Israelsen | November 2019

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There can be a serious disconnect between investors and the indexes they reference—which can lead to a great deal of benchmarking confusion.

 

As found in the Merriam Webster dictionary, the term “benchmark” has the following definitions:

  1. a mark on a permanent object indicating elevation and serving as a reference in topographic surveys and tidal observations.
     
  2. a point of reference from which measurements may be made.

These definitions clearly suggest that a benchmark serves as a point of reference. The real key here—in the world of investments—is selecting a performance benchmark that is similar to the portfolio being measured against it. This often does not happen, which is why performance benchmarking can sometimes be sheer lunacy.

For example, the performance of a diversified portfolio that contains stocks, bonds and diversifying asset classes (real estate, commodities, etc.) is often compared with the S&P 500 index—an index that only contains large-cap U.S. stocks. At first blush, this may seem reasonable inasmuch as the S&P 500 is a well-known index. Here’s the problem: The S&P 500 is not similar to a broadly diversified, multi-asset portfolio. Using the S&P 500 as the de facto performance benchmark for a wide variety of investment portfolios is analogous to comparing the taste of salsa to one of its ingredients, say tomatoes. Salsa contains tomatoes, but it also contains a variety of ingredients that make it—collectively—quite different than any of its individual ingredients.

Consider the following conversation:

“How do you like the salsa?”

“Oh, it’s great … but when I compare it against sliced tomatoes it tastes quite different.”

“Really? You’re kidding, right? Of course it tastes different than raw tomatoes. Why are you comparing salsa against tomatoes?”

“Well, I figured that since salsa contains tomatoes that would be a reasonable comparison.”

“Yikes! That’s crazy. Salsa should only be compared against another type of salsa.”

How does this relate to the performance comparison of different types of portfolios? Consider the following conversation:

“How do you like the diversified, multi-asset portfolio?”

“Oh, it’s great … but when I compare it against the S&P 500 it performs quite differently.”

“Really? You’re kidding, right? Of course it performs differently. Why are you comparing a diversified portfolio against one of its ingredients?”

“Well, I figured that since the portfolio contains large-cap U.S. stocks that would be a reasonable comparison.”

“Yikes! That’s crazy. A diversified portfolio should only be compared against another type of diversified portfolio.”

As shown in Figure 1, comparing a multi-asset portfolio against only one of its ingredients is not helpful, valid or even logical. The primary reason it’s often done is because of habit and because it’s easy to track the performance of an index that is publicized as broadly as the S&P 500. However, habit and ease are seldom the hallmarks of “best practice.”

So, what is the correct “point of reference” that could serve as an appropriate performance benchmark for various investment portfolios? There is not just one—there are many.

Permit me to suggest appropriate benchmarks for various investment portfolios (see Table 1). If your portfolio comprises primarily large-cap U.S. stocks (say, over 80% of your portfolio) then the S&P 500 is an appropriate benchmark. Conversely, if your portfolio is primarily a mixture of U.S. stocks and U.S. bonds, a likely benchmark would be the Vanguard Balanced Index fund (VBIAX).

However, if your portfolio comprises a broad selection of asset classes, including U.S. stocks, non-U.S. stocks, real estate, resources and commodities, U.S. bonds, non-U.S. bonds and cash, an appropriate performance benchmark is the 7Twelve Portfolio.

A multi-asset portfolio (think salsa here) should be compared against a multi-asset index. Enter the 7Twelve Portfolio, a portfolio model that incorporates 12 different asset classes in equal portions. The 12 asset classes are large-cap U.S. stock, mid-cap U.S. stocks, small-cap U.S. stocks, non-U.S. developed stock, emerging stock, real estate, natural resources, commodities, U.S. bonds, Treasury inflation-protected securities (TIPS), non-U.S. bonds and cash. (Full disclosure: I am the developer of the 7Twelve Portfolio.)

TABLE 1
Benchmarking Suggestions
Appropriate indexes for various types of portfolios.

What’s in Your Investment Portfolio? Appropriate Performance Benchmark
Primarily large U.S. stocks S&P 500 index
(https://us.spindices.com/indices/equity/sp-500)
Primarily small U.S. stocks Russell 2000 Index
(https://www.ftserussell.com/products/indices/russell-us)
Primarily stocks in developed non-U.S. economies MSCI Europe, Australasia, Far East Index (EAFE)
(https://www.msci.com/eafe)
Primarily stocks in emerging non-U.S. economies MSCI Emerging Markets Index (EM)
(https://www.msci.com/emerging-markets)
Primarily U.S. bonds Barclays Capital Aggregate Bond Index
(http://performance.morningstar.com/Performance/index-c/
performance-return.action?t=0P00001G5Lregion=usa&culture=en-US)
Primarily publicly traded REITs Dow Jones U.S. Select REIT Index
(https://us.spindices.com/indices/equity/dow-jones-us-select-reit-index-usd)
Primarily commodities Deutsche Bank Liquid Commodity Index
(https://index.db.com/dbiqweb2/index/dblci)
Primarily cash Three-month Treasury bill
(https://www.treasury.gov/resource-center/data-chart-center/interest-rates/
pages/textview.aspx?data=yield)
Primarily large U.S. stocks and U.S. bonds Vanguard Balanced Index fund (VBIAX)
(https://investor.vanguard.com/mutual-funds/profile/VBIAX)
Broadly diversified mixture of various asset classes 7Twelve Portfolio*
(http://www.7twelveportfolio.com/Performance.html)
*Index-based 7Twelve Portfolio includes the following indexes: S&P 500, S&P MidCap 400,
S&P SmallCap 600, MSCI EAFE NR, MSCI EM GR, S&P Global REIT, S&P North American Natural Resources,
Deutsche Bank Liquid Optimum Yield Diversified Commodity Index TR, Barclays U.S. Aggregate Bond,
Barclays U.S. Treasury U.S. TIPS, Barclays Global Treasury USD Unhedged, USTREAS Stat US T-Bill 90 Day.

 

Of Indexes and Investors

There can be a serious disconnect between investors and the indexes they reference—which can lead to a great deal of benchmarking confusion. Actual investors have been (or should be) building diversified, multi-asset portfolios. The problem has been a lack of multi-asset, broadly diversified indexes to serve as appropriate performance benchmarks. My 7Twelve Portfolio can serve as an appropriate benchmark for a broadly diversified portfolio, and S&P Dow Jones Custom Indices now calculates the performance of the 7Twelve Index based on my portfolio. It is available at: www.customindices.spindices.com/indices/custom-indices/lunt-capital-7twelve-moderate-index.

The annualized performance of several key benchmark indexes is shown in Table 2. As can be seen, the performance difference between “benchmarks” can be large—hence the importance of using the most appropriate one.

Consider the performance differential between U.S. bonds (as measured by the Barclays Capital U.S. Aggregate Bond Index) and U.S. large-cap stocks (S&P 500). For the three-year period of 2016–2018, the performance difference was sizable: 2.06% for bonds vs. 9.26% for stocks. However, over the past 20 years from January 1999 through December 2018, U.S. bonds actually came close to the performance of the S&P 500 (4.55% vs. 5.62%). The main point is simply this: bonds should not be used to benchmark stocks, or vice versa.

As you can see, the S&P 500 will often outperform a broadly diversified portfolio (the best-performing indexes are highlighted). The three- and 10-year returns of the S&P 500 are considerably higher than the 7Twelve Portfolio, for example. However, over the past 20 years we see the value of broad diversification. The index-based 7Twelve Portfolio produced an average annualized return of 6.83% vs. a 5.62% return for the S&P 500. However, those two are not the same thing—so they should not even be compared … remember!

Practically speaking, it’s fine to look at the performance of the S&P 500. It just shouldn’t be used as a performance benchmark for a portfolio that is broadly diversified across multiple equity and fixed-income asset classes.

All of this reminds us why the performance of the S&P 500 (or any other index that measures the performance of only one asset class) is an inappropriate performance benchmark for a portfolio that includes a variety of asset classes.

Discussion

Richard from CA posted over 6 years ago:

I diversify by using different strategies in different accounts. Another local AAII member suggested this as appropriate after he observed that strategies work until the do not work, Then they do not work until they start working again. A benchmark is something that we use to measure how well a particular portfolio strategy is doing. The author is essentially arguing to change the markings on a ruler, depending on what you are measuring. This is a terrible way to chose the best strategy or know how well your portfolio is doing. A ruler must be based on a standard! Rather I use two benchmarks, the S&P 500 and a Money Market Fund, which can be approximated by either the Fed Funds Rate of a 3 Month T-Bill. This supplies a constant ruler against which to judge performance. Most portfolios will beat a Money Market and lag the S&P 500. One compares various portfolio strategies by seeing how much the portfolio strategy exceeds the return of a money Market and lags the S&P 500 return. Comparing the 7/12 portfolio against the S&P 500 and a Money Market and comparing those measurements against other portfolio strategies will help you decide which portfolio strategy or approach you wish to adopt.


Joe from TX posted over 6 years ago:

I found the article interesting, but have a different approach on Benchmarking. I invest only in Mutual funds and ETFs. I examine my portfolio performance quarterly and invest in a diversified allocation. My quarterly report assigns comparative indexes to each investment many of which are the same as used in the article. I construct 5 different "Benchmarks" and use them for slightly different purposes. One is a benchmark constructed using the comparative indexes returns weighted by the actual allocation. Another is an index constructed using the MS category return of each investment again weighted by the actual allocation. I compare my actual performance to these two benchmarks as they are nearest my allocation. The other 3 benchmarks are the Schwab Moderate and Moderate Conservative Benchmarks and a traditional 50/50 Benchmark of S&P 500 return and the BBgBarc US Agg Bond return. I use these benchmarks to help guide allocation changes since they measure other investing routines.


Barry C Johnson from Texas posted over 6 years ago:

The article does not state how the author USES his composite 12-factor benchmark to improve the performance of his investments or the results he has achieved using this process to improve overall portfolio performance. Superior analysis would be valuable "IFF" if it produces superior results. I would like to hear the comparative results for the author's portfolio(s). Perhaps that would be a great followup article.


Frederic Corwin from Florida posted over 6 years ago:

Why not simply compare the results of each asset class against the appropriate index for that class? There is no need to construct a composite index.


Gary Koenig from TX posted over 6 years ago:

I have always found Dr. Israelsen's articles (in the AAII Journal and other publications) enlightening and valuable, especially in a world conditioned to think that the S&P 500 and maybe the US Aggregate are the be-all and end-all (if we can agree to ignore the DJIA). I'm posting because of some recent work I've done looking at my and others' "diversifed" portfolios in the context of the recent drawdown. One of the revelations to me was how well a 60/40 or 50/50 blend (using Vanguard Total Stock & Total Bond Admiral funds) has held up using 12/31/19 or 2/19/20 as the starting points, and 3/24/20 as the end point. Today I happened to come across a page from this article that I had saved when I read it, and decided to go to the S&P website to get the 7Twelve data, and M*'s website to get data for the Vanguard Balanced. Here are the (somewhat surprising to me) results, through 3/31/20: 7Twelve: 1Y ROR -11.70% 3Y ROR -0.47% Risk 10.75% 5Y ROR 1.02% Risk 9.68% 10Y ROR 3.60% Risk 9.87% VBIAX: 1Y ROR -1.74% 3Y ROR 4.69% Risk 9.43% 5Y ROR 5.06% Risk 8.45% 10Y ROR 7.88% Risk 8.12% The return numbers aren't shocking given that VBIAX is essentially 100% domestic, and 7Twelve is probably 20%+ foreign and contains commodities, etc., but I am suprised by how much less volatile the simple 60/40 has been. The fund also has a 7 bp drag which the blended index does not. To Dr. Israelson's main point, I'm also in no way meaning to suggest that VBIAX is a legitimate benchmark for the 7Twelve, but maybe, just maybe, it is a decent benchmark for the average saver/investor who is embarked on a long-term plan for retirement, etc., a sanity check, if you will.


WILLIAM B from PA posted over 5 years ago:

The standard is the standard.


Sneha J from IND posted over 5 years ago:

Hi, I prefer to look only at the following 12 ETF ticker symbols if I want to see the performance of various 'INDEX'es >>> 1. FNGS > NYSE FANG + Index, 2. QQQ > NASDAQ - 100 Index, 3. DIA > DJ Industrial Average 4. ONEQ > NASDAQ Composite Index, 5. VONE > Russell 1000, 6. VTWO > Russell 2000, 7. VTHR > Russell 3000, 8. VXF > Extended Market, 9. SPTM > S & P Composite Stock Market, 10. ITOT > Core S & P Total U.S. Stock Market, 11. VTI > Total Stock Market, 12. VT > Total World Stock. If I would have made a 'basket' of all these 12 ETFs in equal proportion, then the following numbers get revealed >>>> $ 10000/- invested as on 30th November, 2019 would have turned out to $ 15417/- (pre-tax) as on 3oth June, 2021 {after 19 months-> moth to month basis} CAGR = 31.45% impressive isn't it? Prakash P. Joshi Mumbai, INDIA (On behalf of my daughter who is AAII member)


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