Far too frequently portfolios are benchmarked against the S&P 500, even though the S&P may not be an appropriate benchmark due to the makeup of the portfolio. How might one go about setting up a customized benchmark without spending hundreds of dollars for software? There are several required steps to building a customized benchmark. While the following is not a perfect benchmark, it is a major step forward in measuring the Internal Rate of Return (IRR) for portfolios that hold assets other than large-cap stocks.
- Set up a Strategic Asset Allocation plan for the portfolio. The portfolio can be built around market sectors, individual stocks, asset classes, or a combination of all three. The following screen-shot is an example of a portfolio constructed around 17 asset classes. The target bands for this portfolio are +/- 30%. The target percentages have the white background and the percentages with the colored background measure the current holdings.
- Find an investable index that represents each asset class. There are several ways one can approach this problem. One can use the total market index fund VTSMX as the benchmark for the nine asset classes found in the upper left-hand corner of the above table or one can break the benchmark down into individual parts. For example, IEV or VTV can be used as the index (benchmark) for all holdings in the Large-Cap Value asset class.
- Once the Strategic Asset Allocation plan is in place and an investable index fund or non-managed index ETF is selected for each asset class, invest a small amount in each index to establish a reference for starting the customized benchmark.
In the above example, 30% of the portfolio is allocated to U.S. Equities and 25% to international markets. Walking through the other allocations we have: Cash = 1%, Bonds = 9%, Domestic Real Estate = 15%, Commodities = 5%, International Real Estate = 10%, and International Bonds = 5%. In this example I will use the VTSMX index fund as the benchmark for all U.S. Equity holdings rather than break it into nine different asset classes. Similarly, developed and emerging international markets are benchmarked by VGTSX instead of dividing them into two asset classes. This choice is up to the individual investor.
The customized benchmark Internal Rate of Return calculation looks like the following. The ticker symbol represents the IRR for each index benchmark.
I used TIP for cash holdings in this example. If one knows the ticker of the money market used to hold cash, include that in the calculation. The key is to hold a few shares in each of the benchmark holdings so it is possible to calculate the Internal Rate of Return for each. Each index IRR is multiplied by the target percentage based on the Strategic Asset Allocation plan.
To make all these calculations easier, a spreadsheet is available to investors interested in not only tracking the IRR of their portfolio, but tracking the IRR of a customized benchmark. Look under Blogroll in the right sidebar. If you are unable to access and open the spreadsheet, contact me (firstname.lastname@example.org) for additional help. Spreadsheet audio/video help sessions are available.