Using Benchmarks 101 - A Brief Overview

by: Retired Investor
Summary

Using one simple benchmark won’t provide an investor with useful information. You need to use a composite benchmark which are fairly simple to generate.

If you use commonly available benchmarks, you are comparing apples to oranges. You need to use Total Return benchmarks. These are hard to find for free but there are options.

Picking the best benchmark is important if you are buying a benchmark-based ETF. I will show some examples where it makes a big difference.

Introduction:

Benchmarks are used by professional asset managers to know how they did versus particular asset class(es). I worked for one where our bonus was based on how the investments did versus our composite benchmark. Each benchmark provider sets the rules for what assets they will include and how the benchmark will be weighted (market versus equal weight or like the DJI, price-weighted). The ones you see in most papers are market-weighted, price-only measurements. They do not include dividends or interest payments. For a High Yield bond index, that makes a very big difference!

Recent SA articles have said investing to a benchmark guarantees the investor will just be average. Those authors offer their services to help you beat a selected benchmark. Professional managers of CEFs and actively-managed Mutual Funds and ETFs try to beat their selected benchmarks for you (for a fee of course). Most of the time these active funds fail to do so. So, if you are actively managing your portfolio AND failing to match your benchmark, you might want to consider passive ETFs and mutual funds or signing up for a service that specializes in the asset class you are interested in. From that perspective, benchmarks provide useful information.

Price Versus Total Return benchmarks

Over the past 12 months, the S&P 500 benchmark returned 3.76% based on price only and 5.88% when dividends were included (most benchmarks assume reinvestment of dividends). Thus, 2.12% of the return came from dividends, or about 36%. So, if your portfolio was up 5%, you look good using a price-only benchmark but failed to match the more accurate total-return benchmark. Compound that year after year, it starts to add up.

Building A Composite Benchmark

Unless you only invest in one narrow segment of the investible universe, you need to build yourself a composite benchmark. Picking the components to use and the proper weights is the difficult but critical part but also totally up to you. If you invest in small-cap US stocks, using the S&P 500 benchmark might not be appropriate. Once you decided all that, Excel can be used to come up with the composite benchmark’s performance. I included an example:

Where Column D equals Col B & C multiplied together and Cell D6 uses the SUM function using cells D3:D5. In this example, the composite benchmark returned 4.4% for the select time period. Remember, the return numbers need to be the Total Return, which includes dividends/interest, and not just price movement.

Finding Total Return Benchmark Results To Use

Unless you have access to a service like Bloomberg or other fee-based product, finding Total Return benchmark results is near impossible! But not to worry! I use the results of ETFs based on the benchmark components I want to include. With their low fees, the tracking error should be minimal. Here are two examples that show the effect fees have:

Source: Bloomberg

I used the main ETF for International Developed Markets' equities and the S&P 500 to show how using the ETF might differ from the actual total return benchmark. Below is a partial list of possible ETFs you can use for building a composite benchmark. Where possible, try using the same vendor for equities or fixed income so your choices don’t duplicate assets or countries (FTSE and MSCI classify South Korea differently as to Developed versus EM).

I noticed that SA Portfolio only shows price performance so you need to use another source to get Total Return results for any ETF you use. Most broker sites should provide this - Fidelity does.

My Composite Benchmark

These ETFs and the YTD return on my Stable Value holdings comprise what I started using for my benchmark as of July 1st when I lost my automatic links in my XLS due to retiring. I plan on adjusting this annually to best match our overall account structure.

ETF used Purpose weight Return
VTI US Equities 30.0% 17.4%
ACWX Non-US Equities 10.0% 12.3%
CORP Corporate debt 12.5% 9.6%
HYG High-Yield debt 12.5% 9.8%
CDs CDs/Stable Value 35.0% 1.2%
YTD return 9.3%

Benchmarks Can Affect Performance Of An ETF

I recently wrote an article about ROOF, a small-cap REIT ETF that is performing poorly against the benchmark it is based on. Even worse is the fact there are better-performing benchmarks in the small-cap REIT arena. Over the past five years, the ETF’s benchmark is up 5.3% whereas the DJ REIT one is up 9.3% - a big difference. A second example is in the small-cap equities arena, where the iShares Russell ETF (IWM) has lagged the performance of the iShares S&P 600 ETF (IJR) 12.75% versus 14.21% over the past ten years, mostly due to their choice of benchmarks.

When Using A More Generic Benchmark Makes Sense

There are two cases where I might use a benchmark not totally aligned with my holding. First, is in deciding which US equities market segment I want exposure to. Then I want to know if my investment choice is doing better than the large-cap universe (most people’s gold standard) so I compare the other ETFs against SPY to know if going smaller is paying off. The other time is comparing variations within an asset class against the standard bearer ETF for that class. An example is comparing MOAT or SPYD against SPY versus the benchmark for the individual ETF as the purpose of buying ETFs like MOAT or SPYD is to outperform SPY; otherwise why do it!

Conclusion

Each week, Fitbit sends me an email showing how many steps I did daily and which days I reached my “benchmark.” After I retire next month, I plan on changing my benchmark to more steps daily. I use this as a great guide to know how I am doing against my walking goal. I see investment benchmarks the same way. They provide useful information that helps guide your investments but not control them! I don’t walk in the rain just to meet my walking benchmark I assure you. A benchmark should be viewed as a tool, just like Dividend Discount Models, PE ratios or CEF premiums/discounts. The more you know, the better off you are. Thanks for reading.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.