A key aspect of investing is measuring your results: How much has your portfolio gained or lost over a given period of time? This information in and of itself is meaningful, but it doesn’t tell the whole story.
It’s important to also measure your performance against some sort of benchmark to determine how well your portfolio’s performance stacks up. If you're investing on your own, this is a helpful way to track your progress over time. If you're working with a financial advisor who manages your investments, it can help you track his or her performance against a suitable peer group.
But it's important to make the right choice. Choosing an investment that doesn't match your risk profile might make it look like your investments are underperforming - or over-performing. So which should you choose?
The S&P 500
The S&P 500 is one of the most widely followed stock market indexes. It is widely quoted on cable financial news networks and in the financial press. For many individual investors and professionals, it serves as the de facto investing benchmark.
The S&P 500 is a measurement of the 500 largest U.S. stocks and the stocks represented are weighted by their market capitalization. This is sum of the share price of each stock times the number of shares outstanding.
Because the S&P 500 is market-cap weighted, the largest stocks can be inordinately weighted in the index. A recent look at the holdings of the SPDR S&P 500 ETF (SPY) that tracks the index shows that the top ten holdings in the fund comprised just over 25% of the portfolio.
Further, because the S&P 500 only tracks stocks according to their market cap, if a sector of companies is overvalued, it will comprise a larger portion of the index. For example, as technology stocks have outperformed in recent years, they've comprised more and more of the S&P 500. Should a reversal occur, investors will find themselves holding more technology stocks than they otherwise may wish to hold.
Diversification and a Benchmark
The S&P 500 might be a fine benchmark if all of your investment holdings are large cap, domestic U.S. stocks. That essentially is what the S&P 500 tracks.
Most investors, however, have portfolios that are diversified beyond domestic large cap stocks. For example, your portfolio might also include asset classes like:
- Mid-Cap stocks
- Small Cap stocks
- International stocks
And within those asset classes, equities might fall into categories like growth, value, or blend for large, mid and small caps, as well as international stocks. On the international side, equites can also track developed markets or emerging markets. There are many sub-asset classes for bonds as well.
The point is that the benchmarks used should do a better job of tracking where you are actually invested, as well as the percentage of your portfolio that is invested in these areas.
As an example, let’s look at a portfolio that is invested as follows:
If we take this example a step further, let’s look at some hypothetical results:
On a weighted average basis, the portfolio had a return of 5.45% for this hypothetical period versus a weighted average return for the blended benchmark of 6.40%. This type of analysis should be done for various periods of time such as the trailing quarter, year, three years, five years, ten years, etc. For a shorter period of time, underperformance might not really tell us much, but over longer periods of time, underperformance might indicate a trend.
Understanding Relative Performance
Relative performance tells you how your portfolio stacks up against a benchmark. No benchmark is the end-all be-all, but it can be a good starting point. If your portfolio is underperforming its overall benchmark over most time periods it should at least raise some questions that cause you to take a closer look at what you are doing, or how the advisor you’ve hired is managing your money.
Relative performance also pertains to individual holdings, especially with mutual funds and ETFs. For example, if you are looking to invest in an actively managed ETF, it makes sense to track its performance over time against a passive mutual fund or ETF that tracks a mid-cap benchmark like the S&P 400 index, the Russell Midcap Index or the Wilshire US Midcap Index. Has the actively managed fund outperformed over time? Is the extra expense that the active fund charges offset by superior performance or lower risk over time?
Another way to look at the relative performance of a fund or ETF is to see where it ranks relative to its peers in the same asset class or category. Morningstar ranks funds and ETFs within their appropriate category so this comparison can be pretty easy to make.
Don't Forget About Risk
Performance isn’t the only benchmark; risk should come into play as well. Either at the individual holding level or at the portfolio level, how do your investments stack up against a benchmark? For example, a diversified portfolio might still be compared to a single benchmark like the S&P 500 in terms of the percentage of the benchmark’s return the portfolio captures compared to its relative risk. One way to look at the this could be to compare the portfolio’s beta compared to the S&P 500. A beta of 1.0 would say that the portfolio will move in lockstep with the index. A beta of 0.7 says that the underlying portfolio will likely go up or down 70% as much as the index.
If your portfolio has a beta of 0.7, but consistently earns 80% of the return of the S&P 500, you are doing well on a risk-adjusted basis. Portfolio tools like those offered by Morningstar and other sites can help with type of measurement. This is also a good question to ask of your financial advisor.
The Bottom Line
Using a benchmark is a good way to determine how your investments are performing on a relative basis, either on the portfolio level or the individual holding level. Raw investment performance on its own only tells part of the story.