Comparing to Similar Portfolios Helps Manage Risk and Spot Trends

Key Takeaways:
  • Benchmarking is a deep dive into portfolios and funds that are similar to yours.
  • Benchmarking helps investors set expectations for portfolio performance.
  • Shocks to the market can shake investor confidence… but stay the course.

 

Whether the stock market is calm or volatile, investors want to know how their portfolios are performing. Benchmarking yields the most accurate and actionable insights for sophisticated investors who want to know what their next moves should be.

As the name suggests, benchmarking is a process of comparing the investments you hold to other similar investments, and assessing the results to determine if you should make changes in your holdings. To be a meaningful benchmark, the comparable fund used to evaluate your model should be one that like-minded investors would consider investing in.

Why Benchmark?

Benchmarking regularly helps set expectations for portfolio performance. By looking at the performance of benchmark funds over a 5-, 10- or 15-year period, you get a general idea of risk and risk tolerance.

The general idea is that the point at which an investor’s portfolio stands now is where the comparison can start, but it’s not where it ends. Over time, regular benchmarking provides a timeline view of a portfolio’s performance that enables the investor to recognize trends and opportunities. The benchmark is used to maximize the portfolio’s performance without adding too much risk.

What Makes a Good Benchmark Comparison?

Benchmarking is more than comparing your portfolio with the S&P 500 Index. It is a deep dive into portfolios and funds that are similar to yours and that provide meaningful comparison. When looking for funds to compare with yours, consider these characteristics:

  • The tenure of the managers of the benchmark fund. The current manager or management team should have at least a five-year track record. If the fund recently got a new manager, pass on it. Watch it for a few years and, perhaps, add it back in when it has a track record under the new manager.
  • Determine if the fund is actively or passively managed. Also consider what types of asset classes constitute the fund.
  • Historical performance that compares well to other benchmarks.
  • Diversification in multiple asset classes. You’re not looking for a benchmark in a single asset class or one that is highly concentrated in a certain type of funds.
  • Diversification of funds. Consider looking for benchmarks with at least 10 to 20 funds.
  • Look at how often the benchmarks are rebalanced. If you notice the same allocation to each fund after five years, it may still be a good benchmark, but not the strongest.

Understand the Key Metrics to Evaluate

The five key metrics that give a comprehensive benchmark include:

  • Look at a minimum of five or 10 years’ worth of data.
  • We recommend looking at two indicators of risk, the first being standard deviation, which measures how far values in a dataset typically deviate from the mean, providing an indicator of the volatility or risk. The second risk metric would be downside risk, which measures the potential loss in value of an investment due to adverse market conditions, focusing only on negative deviations from a target or benchmark.
  • The Sharpe Ratio, which compares the excess return of an investment (above a risk-free rate) to its volatility (standard deviation of returns). It helps investors determine whether an asset’s returns are due to smart investment decisions or simply high risk.
  • The Treynor Ratio, which evaluates how efficiently a portfolio generates returns relative to the market risk it takes. It is a performance metric for determining how much excess return was generated for each unit of risk taken on by a portfolio.
  • Tracking Error, which evaluates how closely your portfolio mirrors its benchmark.

These are measurements that many investors — even sophisticated investors — would not necessarily have experience in researching, so it’s important to work with your investment advisor to create a meaningful, actionable benchmark of your portfolio.

When the benchmark funds are identified and the metrics are performed, the investor is looking for a track record and specific measures, such as duration on the fixed income side and asset allocation on the equity side. They’re also looking for comparisons on the international side — how much investment is in Asian or European equities?

How to Act on Benchmark Results

Sophisticated investors expect a certain return, and they generally know what to expect from their advisors and portfolio managers. Benchmarking is a way to ensure that they are getting the results they expect, and if not, it can show where the weaknesses are and what changes need to be made.

If the results of a benchmark are not what an investor wants or needs, their portfolio will likely be evaluated for any weaknesses, such as overconcentration, which may result in significant losses if even one stock or one sector loses value.

If you’re expecting a 12% return over five years, and a benchmark shows that a 25% return is potentially obtainable by making key changes, you will likely shift your target and make the changes.

But when benchmarking indicates underperformance in a portfolio, sophisticated investors understand that they may want to exercise caution before making changes. Taking a broad look at the market first can explain momentary declines. Is the market being buffeted by a rise in interest rates? Or by international conflict?

Understanding why the results of a benchmark are not what you expected can help determine whether to make changes in your portfolio or stay the course.

Impact of Domestic and International Events

At a time when interest rates, energy prices, inflation and international events are volatile, market performance reflects the turmoil as prices go down and portfolios lose value. It’s important to remember that over time, the stock market rises and short periods of volatility are ultimately overcome. The typical recession in the US economy lasts anywhere from 12 to 18 months — a time period that most investors can stomach losses in when they have a long-term focus/goal.

During unsettled periods, we recommend benchmarking more often than usual to ensure that sensitive stocks are not dragging your portfolio down too much, or that upside opportunities are not being missed. At Adams Brown, we typically benchmark our model portfolios quarterly, and this year we’re building in a few extra meetings.

Shocks to the market are an additional consideration when benchmarking shows unusual activity. The recent SpaceX IPO was one such shock that hit the market at an unprecedented market capitalization valued at more than $1 trillion. Space is a new sector in the stock market, and one that we are watching closely. There are many companies in the sector already, besides SpaceX, which are performing admirably and will provide solid benchmarking metrics for investors who want to add space to their portfolios.

So, factors that can significantly impact benchmarking results include:

  • Domestic and international conflict
  • Interest rates at home and abroad
  • Shocks to the market

Savvy investors understand that the impacts of these events on their benchmark portfolios don’t necessarily mean they should make immediate changes in their holdings, but that they bear watching and may require action in the future.

What Should Investors Do Now?

If your most recent benchmark indicates that changes to your portfolio may be in order, discuss the matter with your investment advisor before making any moves. There may be extenuating circumstances that you haven’t considered, or opportunities that could impact your decision.

Above all:

  • Stay invested. The likelihood of an international shock significantly damaging your portfolio is infinitesimal. But studies have shown that if you miss the best 10 days of the market in any given year, your portfolio will be negative for the year. So, stay invested.
  • Look for diversification, and work with someone who actively manages your portfolio and is looking at the market daily, adjusting as needed. In a 3- to 5-year period, you should be able to outperform the benchmarks.
  • Invest in new ideas. Some people have expressed concern about how SpaceX will affect the markets. But there are many companies in the space industry. Look at the sector, not just one stock. If you’re ready to invest, put a small percentage — say 5% — of your portfolio into the sector. In other words, lean into new ideas. They will give your portfolio an edge.

Questions?

If you would like to discuss regular benchmarking of your portfolio, contact an Adams Brown Wealth Consultant.