When investing, benchmarks are often used as a tool to assess the allocation, risk and return of a portfolio. Benchmarks are usually constructed using unmanaged indices, exchange-traded Funds (ETF) or mutual fund categories to represent each asset class. Comparisons can be made for almost any period.
The first step in selecting a benchmark model is determining your risk profile. Many factors go into determining a risk profile, including age, how long the funds will be invested, and other financial resources, such as a cash reserve. There are many tools available to help assess your risk profile that usually rank you on a scale. For instance, you could have a risk profile that is a 7 out of 10.
Next, you need to decide on an overall asset allocation model that mirrors your risk profile. Since most people have diversified portfolios, the allocation should include multiple asset classes, for example, bonds, U.S and non-U.S. equities, commodities, and cash. You need to determine what asset classes to include, as well as what percent of your portfolio should be in each asset class. (For related reading, see: Concentrated Vs. Diversified Portfolios: Comparing the Pros and Cons.)
Allocations can be relatively simple, using broad indices, such as the Russell 3000, MSCI EAFE and Barclays U.S. Aggregate Bond, or more complex by breaking a broad index, such as the S&P 500 into smaller sectors, such as U.S. large-cap value, blend and growth.
Within your overall asset allocation model, you may also need to use different benchmarks depending on how long the funds will be invested. The appropriate allocation of an investment with a 3-5 year time horizon is entirely different from a long-term investment of 10 or more years. So your long-term investments could be allocated 70% to equities, and 30% bonds, while your 3-5 year investments would be the opposite.
One way to get a sense of how to allocate the asset classes in a benchmark is by looking at the composition of the many asset allocation and target mutual funds offered by investment companies. The funds are allocated by percent, such as 60% equity, or by a target date similar to your investment horizon.
The allocation and risk vary widely among investment companies; so it makes sense to look at several mutual funds. Among the top-rated funds, it’s also important to examine the investment strategy since any excess return may have come from taking more risk.
Risk includes both volatility and variability. Volatility measures the and holdings potential for change, up or down, in portfolio value; while variability measures the frequency of the change in value. For example, U.S. government or high-quality investment grade corporate bonds, which have less variability and volatility, are considered safer investments than commodities, which can have frequent and large moves up and down in value (as we have recently seen with energy prices).
One way to evaluate if the return came from taking more risk is by looking at the Sharpe Ratio. The Sharpe ratio measures the average return earned in excess of a risk-free investment, such as a Treasury Bill. A higher Sharpe ratio indicates a superior overall risk-adjusted return.
Building a Benchmark
Building a custom benchmark requires using some kind of software. There are many companies that sell subscriptions to software that allows you to managed portfolios and build benchmarks. You can build multiple portfolios and benchmarks as well as generate a variety of statistical measures, such as the Sharpe ratio, standard deviation and alpha.
However, you can also build a benchmark and glean quite a bit of information using the free. software tools offered by some of the ETF companies. Also, if you have an investment account, many of the larger brokerage companies let you select from different indices and mutual funds that can be used to compare the performance of your portfolio.
The Bottom Line
Once you decide on a benchmark, you can use it to evaluate your portfolio. You may discover you are taking too much or too little risk. Also, the benchmark provides a guideline for periodically re-balancing your portfolio allocation to help manage risk. (For related reading, see: Rebalance Your Portfolio to Stay on Track.)