Benchmarking Investment Performance

What is sensible? What is sneaky?

I am on record saying that the only benchmark that really matters for the performance of your portfolio, is whether the returns allow your financial plan to sing or whether they don’t.

But one of the more challenging concepts to wrap your head around with investing, is that outcomes are relative rather than absolute. Being a properly informed investor involves understanding the performance of your portfolio in the context of the wider world.

Say my portfolio is up by 5% in a year, that’s cool. But if the overall market is up by 10% then we need to have a bit of a look under the bonnet to understand why.

In order to aid in this endeavour, this week I have listed the most common benchmarks that I see people use, which ones I use and (most importantly) the ones I see mis-used.

As a former portfolio manager, I can tell you that there is no such thing as bad performance - just the wrong benchmark…

Let’s get to it.

FTSE 100

Don’t. Just stop.

The UK market now represents just 3.5% of the overall global stock market. If your portfolio is in any way properly diversified, then the performance of the FTSE should be almost irrelevant to the returns you experience.

Would you benchmark your portfolio against the Australian market? No you wouldn’t.

“You call that an index?”

But “home country bias”¹ is a very real thing, and it is also the only stock market index that is really in the public consciousness - with the possible other exception of the Dow Jones.

Which brings us neatly onto…

The Dow Jones/S&P 500

The American index now dominates the global stock market, and so as a benchmark it is somewhat of a better measure of a portfolio’s performance than the FTSE.

But because the US market has gone like the clappers over the last decade, you will never see a wealth manager benchmark performance against the S&P 500. Just doesn’t happen.

But you will absolutely see them benchmark against the FTSE. I wonder why?

Source: FE Analytics. Returns are shown in GBP terms for the S&P 500 and FTSE 100 indices. Dividends reinvested.

The Dow, incidentally, despite its long and storied history is a hopeless benchmark.

This is due to the way it is constructed. It attributes higher weights to the stocks with bigger prices, which means that a company with a share price of $100 will have twice the impact on the performance of the index than a stock with a price of $50 - even if the latter company is ten times the size of the former.

This objectively makes no sense, and almost every other index on the planet (including the S&P) operates on a “market cap weighted” basis - which means that the share price is irrelevant. It is the size of the company that dictates the impact on the index. Nvidia’s share price moves the dial by an order of magnitude more than, say, some two blokes in a garage type micro-cap - which is kind of the way it should be.

Anyway, despite the States representing around two thirds of the global equity markets at the moment, it still isn’t a great benchmark to use.

You should absolutely be diversifying globally, and not just investing into one country’s market. If you do, you have to be mentally prepared to enter into a world of hurt at some stage (if the past is any guide to the future).

The ARC Indices

ARC (Asset Risk Consultants) produce a series of indices for private investors to use to benchmark their wealth manager.

These indices are (meant to be) constructed using actual real life client performance data. Data which is submitted by the wealth managers themselves - and the respective firms can then use their performance in reporting and marketing to clients (or not, depending on what the numbers look like).

I fully applaud ARC for what they have tried to do, shine an objective light on the performance of the industry. But their benchmarks are, in my opinion, fundamentally flawed.

As the data is submitted by the portfolio managers themselves, they are literally marking their own homework. And I have deep suspicions that different firms use different methodologies in their submissions. If there has been jiggery pokery, the end user would never know.

It was a running joke in my old shop that everyone seemed to beat the ARC benchmarks. I certainly never came across a discretionary fund manager that seemed to underperform the ARC index over long time periods which, seems odd.

However in my opinion the, rather more existential, issue with the ARC benchmarks is that there is an inherent conflict within the business. They purport to offer insight to the end investor, who can access their data for free - but they are paid by the wealth managers to be able to contribute and share the data in their marketing. I’m not sure ARC know who their customer is but maybe that’s unfair.

In any case, their indices are used more often than not by the wealth management industry to spin the sub-par as half decent. Pay them no mind.

Inflation (RPI, CPI)

Now we’re talking.

The reason we tolerate the occasional fear and concern and worry that investing inevitably entails, is that we want to earn a return over and above inflation - so we can enjoy the same lifestyle, or better, in the future. For this to happen we need the real value of our money to appreciate over time.

This being the case, using inflation as a measure for portfolio performance is eminently sensible. Both RPI (the Retail Price Index) and CPI (Consumer Price Index) are grand, don’t overthink it².

Cash

In a similar vein to inflation, if our portfolio is underperforming cash over an extended period of time - then something as gone very seriously wrong.

For the fourteen years following the financial crisis, the only barrier to outperforming cash was being able to fog a mirror. A monkey with a dartboard could make money in that environment³.

But as cash rates have risen in recent years, it is natural to question whether accepting the risk of an invested portfolio “is worth it”. But the data tell us that most of the time a diversified portfolio outperforms cash over sensible timeframes and this is pretty much the case regardless of where interest rates are at. I will look at this in more detail another day.

The “No Brainer” Portfolio

I first came across this concept via Noel Watson, of Pyrford Financial Planning. They produce some really great stuff which you can check out here.

The idea is that by combining a simple mix of global equities (in my case via the MSCI ACWI index) and global bonds (via the Bloomberg Global Aggregate Bond index) one can build a “no brainer” portfolio.

Just bonds and equities, no attempt to beat the market, just accept the returns that the two asset classes provide. Adjust the allocation between bonds and equities depending on how much temporary volatility you are prepared to accept.

The below chart shows risk adjusted returns over the ten years to 31st May for a 40/60, 60/40 and 80/20 “no brainer portfolio” versus the comparative ARC benchmarks.

It is a massacre.

Source: FE Analytics. Returns for the ARC indices are shown after costs and charges have been deducted. The “no brainer” portfolios have a 1.2% annual fee deducted (1% plus VAT) to allow for a like for like comparison. The no brainer portfolios are also rebalanced quarterly back to their starting allocations.

I really like this idea for benchmarking performance, not just because it (closely, but not exactly) mirrors how I think money should be managed - but it sets a relatively high bar for what is acceptable performance.

Based on the data we have available if we choose to deviate from this, very low cost, strategy - there better be a damn good reason.

Some other things to watch out for when you are looking at performance. It is imperative to understand whether portfolio, and/or benchmark returns are shown before or after charges have been deducted (gross or net). If this information is only found in the small print it usually means performance is shown gross of charges.

The other thing you have be on the lookout for is using strange performance periods to make returns look better. In my view, the only acceptable timeframes to judge performance over are:

• From the start date of the portfolio;

• Over rolling 1/3/5 etc. years to the current day; and

• Individual calendar years/year to date.

Anything wackier, you are probably looking at data mining.

Have a great weekend.

Past performance is not indicative of future returns. None of the above is intended to constitute advice to any individual. If you have questions regarding your own position, please contact a regulated financial adviser.

1. The propensity for individuals to over-allocate to their home, domestic market.

2. CPI is, at the margin, better.

The primary difference between the two is that CPI excludes housing costs (mortgage interest, council tax) whereas RPI includes these. There are also mathematical differences in how the two numbers are calculated, which I won’t explain here because life is too short.

3. I would know.