Asset Allocation And Benchmarking Portfolio

Includes: AGG, BND, SCHZ, SPAB
by: Lowell Herr

A few days ago I read the following comment. I did not question the reasoning behind this statement.

"Calculating return is relatively pointless if you are investing in indices."

While the point of not calculating the portfolio return may make sense for investors who select one or two broad index funds for their complete portfolio, it lacks sound reasoning for investors who construct portfolios as we do here at ITA Wealth Management. It also smacks of laziness or lack of curiosity. Remember the old adage โ€“ "You can't manage what you don't measure." Even indexers manage their portfolios and it can be done more effectively if it is benchmarked appropriately.

While asset allocation no longer occupies the prominent place in portfolio management it did back in the early 1990s after publication of the Brinson et. al. papers, it is still a starting point for portfolio construction. We continue to build our portfolios around eight to 17 asset classes (including cash). By breaking the U.S. Equities market down into smaller index ETFs, we tilt toward sections of the market that tend to perform a little better than the broad market over the long run. At least that is the current argument. No one knows if these tilts will continue to do better than the market. By benchmarking, we can measure both how well the broad portfolio and different asset classes are performing.

Another reason for setting up an appropriate benchmark, such as the ITA Index, is so we have a way to measure portfolio uncertainty. Check the Sortino ratio to see how important it is to measure the return of the portfolio. Investors who do not measure portfolio return miss out on measuring portfolio volatility using the semi-variance calculation.

While neglecting to calculate portfolio return may suffice for the casual investor, it is inadequate for the serious investor.