The Challenge: How To Benchmark Your Investment Portfolio

How to Benchmark & Measure Your Investment Portfolio Performance

One of the biggest challenges you face as an investor is determining how well you’re performing. Sure it might be nice to see your portfolio is “up 12%,” for example, but how do you know you couldn’t have done better?

The primary solution to this problem is to create or find a benchmark against which you can evaluate your portfolio’s performance. In theory the benchmark you choose should be appropriate for all your investment managers.  Unfortunately it’s almost impossible to develop one benchmark for all investors.

Benchmarks are relatively straightforward when you want to measure the relative performance of a money manager who only invests in one asset class like US stocks or bonds. It gets far trickier when you want to evaluate the manager of a diversified portfolio.

Indexes

Most individual investors think they should benchmark their diversified portfolios against a stock index like the S&P 500. That’s probably because such indexes are the only indexes with which they are familiar or the only indexes their financial advisors used in the past.

Unfortunately using a stock index as a benchmark for a diversified portfolio is like comparing apples to oranges.  A pure US stock portfolio has a particular expected return and volatility (risk) profile. A well-managed diversified portfolio should have a slightly lower return than a US stock index and significantly less volatility. The only fair way to evaluate the two types of investments is on a risk adjusted return basis.

Enter the Sharpe Ratio

The Sharpe Ratio was created by William Sharpe, the co-recipient of the Nobel Prize awarded for the creation of Modern Portfolio Theory, to evaluate the relative attractiveness of individual asset classes and portfolios.  It is calculated as follows:

What is The Sharpe Ratio?

The Sharpe Ratio for the S&P 500 over the past 15 years was 0.19.  The Sharpe Ratio for the portfolio Wealthfront recommends to our average investor would have been 0.28 over the past 15 years. That means the average investment portfolio on Wealthfront could have outperformed the S&P 500 by almost 50% on a risk adjusted return basis. *

Sharpe ratios are used extensively by institutional investors to evaluate the performance of their portfolios and component asset classes.  Unfortunately most individual investors are not familiar with the Sharpe Ratio or conditioned to evaluate their portfolios’ performance in terms of risk AND return.  As a result a number of other lower fidelity approaches have been created to help benchmark diversified portfolios.

The traditional approach

The most common approach to benchmarking portfolios is to compare a client’s portfolio to a portfolio that consists of 60% stocks and 40% bonds.  Typically the S&P 500 is used for the stock component and the Barclays Aggregate Bond Index for the bonds.  The problem with this approach is a 60/40 allocation usually doesn’t have the same risk profile as the portfolios against which it is compared.  An investor with significant risk tolerance (say an 8 on Wealthfront’s 10 point scale) should expect both a higher return than a 60/40 portfolio and greater volatility.

Market weighted benchmarks

I had lunch with Bill Sharpe a few weeks ago (Bill and I are colleagues at Stanford Graduate School of Business and previously served together on the board of a financial technology company) and he told me for less sophisticated investors, he currently favors comparing portfolio returns to a portfolio that is weighted by the relative aggregate worldwide market capitalizations of all major asset classes.  Unfortunately this approach also doesn’t address the issue of different investors having different risk tolerances and the required data is challenging to find (Bill is working to make it broadly available).

It probably makes the most sense to compare your portfolio to a mix of indexes based on your particular level of risk. On Wealthfront, that IS the portfolio we manage for you.  It doesn’t make much sense to compare your portfolio to itself.

Projections

That’s why we decided to compare your portfolio to the original projection we provided when you opened your account.  The projection is relevant for your particular level of risk and you can judge us relative to what we said we could do for you.  The downside of this approach is twofold.  First, no advisor can foretell the future and the markets for securities can be much better or worse than expected.  The projection approach will penalize an advisor who does relatively well in an environment where long-term results are worse than expectations.

Second, volatility can have a disproportionate impact on your short-term performance, which can make your results look a lot worse or better than they ultimately will be compared with a projection.  Therefore using a projection as a benchmark is only appropriate for judging long-term performance (but you shouldn’t evaluate your investment returns over a short time period, anyway).

The debate wears on

If you are a current client of a financial advisor, especially one who works for a brokerage firm, it’s unlikely your portfolio’s performance is measured against any kind of benchmark, be it an index, blended index or a projection.

That is probably for a combination of reasons. Most financial advisors worry, perhaps rightly, that you will be overly focused on your short-term results, which as I explained above can vary widely and which aren’t the best way to judge performance. Over the long-term, a benchmark can help reveal an advisor who isn’t doing a good job – another reason that bad financial advisors avoid using them.

If your advisor doesn’t use a benchmark, you should ask which one she thinks is most appropriate. A good advisor will be willing to educate you on the topic. If she still argues against using one, then you might be well served to look elsewhere.

As I said at the outset, none of the benchmarks (including the one we use) are ideal, which is why the debate over which benchmark is best wears on – and why people like Bill Sharpe are still working on the problem.

The advice we can provide with confidence is you shouldn’t compare your diversified portfolio’s performance to that of an individual asset class’s performance.  We’d love to hear your thoughts as to what kind of benchmark you would like to see to help us fulfill our commitment to continuously improve our service.

* Disclosure

To achieve the hypothetical Sharpe Ratios described here, we measured returns for two portfolios for a 15-year period (from 1998-2012): the S&P 500 Total Return, which consists of one asset class, and a Wealthfront taxable portfolio, consisting of six asset classes, with a risk score of seven.  We assumed monthly rebalancing in the Wealthfront portfolio.  In both portfolios we considered expenses and assumed that dividends were reinvested.  In the Wealthfront portfolio, we considered advisory fees.

After we measured the simulated historical monthly returns of both investments over the 15-year time period, we were able to calculate the Sharpe Ratio for each portfolio using the formula described above.  We assumed the “risk free rate” in the formula to be the three-month Treasury bill rates.  For the 15-year period, the Sharpe Ratio for the S&P 500 was 0.19, and the Sharpe Ratio for the Wealthfront taxable portfolio was 0.28.  This hypothetical calculation does not take into consideration the effect of taxes, changing risk profiles, or future investment decisions. This simulation does not represent actual client accounts and may not reflect the effect of material economic and market factors.  The results are hypothetical only. The results of this simulation should not be relied upon for predicting future performance and is not a guarantee of actual performance.

A different methodology may have resulted in different outcomes.  For example, we assume that an investor’s risk profile and target allocation would not have changed during the time period shown; however, actual investors may have experienced changes to their allocation plan in response to changing risk profiles and investment objectives.  Furthermore, material economic and market factors that might have occurred during the time period could have had an impact on decision-making.  Actual investors on Wealthfront may experience different results from the results upon which we based our calculations.

While the data used for its historical simulation are from sources that Wealthfront believes are reliable, the results represent Wealthfront’s opinion only. The return information uses or includes information compiled from third-party sources. Wealthfront does not guarantee the accuracy of the information and may receive incorrect information from third-party providers. Unless otherwise indicated, the information has been prepared by Wealthfront and has not been reviewed, compiled or audited by any independent third party or public accountant.  Wealthfront does not control the composition of the market indices or fund information used for its calculations, and a change in this information could affect the results shown.

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2 Responses to “The Challenge: How To Benchmark Your Investment Portfolio”

  1. Zach March 15, 2013 at 1:55 pm #

    An interesting, tangential topic to this post is how much risk an individual investor should be taking.

    Wealthfront, and many other RIAs, use a questionnaire to imply risk tolerance from responses to plausible investment scenarios. This method seems flawed especially for potential investors who have some knowledge of investment theory. For example, someone in their early 20s who should be theoretically taking a lot of risk in an IRA (or other retirement account) may answer the survey questions in a way to produce a high risk seeking result.

    Additionally, I think people are not very good at being introspective. Somebody’s response to how they may feel in a certain scenario in the future may be different than how they actually respond. It seems like there needs to be a better way to proxy for risk tolerance. See: http://danariely.com/2011/08/30/asking-the-right-and-wrong-questions/

  2. Dan Kane April 3, 2013 at 11:09 am #

    It can still be useful to “benchmark” your client’s portfolio “to itself” even if the portfolio is composed solely of the mix of asset class index funds in the benchmark. The live portfolio involves additional investment decisions, namely the timing and details of the rebalancing transactions. To approach a “pure play” on a given asset allocation, one would have to rebalance the appropriate mix of index funds daily. With no allocation drift, it would have the total return of its asset allocation every day. So its ongoing performance, compounding the daily rates of total return (RTRs), would closely represent the ongoing performance of the asset allocation, missing only intraday variations.

    Some fund providers, say Vanguard, could provide such a fund of their index funds for selected plain vanilla allocations. I benchmark my portfolio against an allocation composite index that mimics such a vehicle. The daily RTR for the index is just the allocation weighted sum of the daily RTRs for the Vanguard index funds representing my portfolio’s asset classes. My interest lies in using the benchmark not simply for comparison, but rather for analysis of my portfolio’s performance.

    One could do the weighting based on a nominal asset allocation. If you did this to create a benchmark for your clients’ portfolios, the performance not accounted for by the asset allocation would have to be attributed to the particular mechanics of allocation maintenance and rebalancing. Or one could do this ex post, based on a portfolio’s actual asset allocations averaged over the time frame of interest. I do this to determine how much of my portfolio’s performance can be attributed to an “effective asset allocation” (see below) during the time frame.

    A good way to visualize my use begins on the usual plot of portfolio return against risk level. Draw a line starting at the risk free rate (RFR) on the ordinate axis, through the point plotted for a portfolio’s risk level and return. The portfolio’s Sharpe Ratio (ignoring the precise mechanics of its computation) is the slope of this line. Assume, for purposes of this analysis, that cash reserves are invested at the RFR and that the cost of margin is also at the RFR. When the portfolio is leveraged up or down to any risk level, either by investing on margin or by holding cash reserves, the resulting return stays on this line.

    Leah Modigliani suggested using this approach to compare portfolios on a risk adjusted basis. While Sharpe Ratio does rank order portfolios on a risk adjusted basis, differences in excess return per unit risk are not easy to appreciate. Modigliani suggested leveraging comparable portfolios to the risk level of their common benchmark (all Large Cap funds, for example, leveraged to the risk level of the S&P 500). Then, at this common risk level, it is easy to appreciate the differences among their risk adjusted returns.

    Richard Marston suggested turning this around for a diversified portfolio, leveraging the benchmarks to the risk level of the subject portfolio (his analysis involved use of both strategic and tactical allocations). From the returns and risk adjusted returns, Marston identified various parts of the performance attributable to different investment decisions. Such detail was only appropriate for institutional investors.

    My own analysis, for an individual investor’s portfolio, breaks out three parts of performance: one attributable to the effective asset allocation, a second representing the portfolio’s taking on more or less risk, and the last representing all other aspects of the portfolio’s management.

    - The first part is the return of the portfolio’s ex post allocation composite index (ACI). Basing the ACI on allocations averaged over the time frame best represents the portfolio’s use of asset classes independent of timing decisions.

    - The second part is the change from the ACI’s return to its risk adjusted return at the subject portfolio’s risk level. This risk increment is significant for portfolios with large cash reserves, those aggressively using margin, or those actively investing in securities with risk levels significantly different from their respective asset classes.

    - The third part is the portfolio’s return less the ACI’s risk adjusted return. This covers active management like choice of securities and timing of transactions. Any major shiftings of allocations over the timeframe, as well as tolerated allocation drift, would also be covered here as essentially timing decisions.

    For an animation illustrating this analysis, see
    http://www.myfinancialperformance.com/IllusKI/SeqG.swf
    The results for my portfolio for five periods are also posted on my website.

    I would be very interested in results of a study applying this form of analysis to a significant sample of individual investors’ portfolios, similar in scope to the study of Odean and Barber. How much does the asset allocation dominate the performance? For what proportion of portfolios is the active management contribution negative (i.e., the simple mix of index funds would have been superior)? Do the portfolios managed by a financial advisor have a different profile from those managed directly by the investor? Do the portfolios with risk levels out of line with their asset allocation do better or worse?

    It occurs to me that you might have a very real interest in getting such a study done. I suspect that your clients’ portfolios would be totally dominated by the asset allocation contribution, and that the study would demonstrate that, normally, that is the best outcome. A simple, initial study – probably very easy for you to run, considering how you manage your clients’ data – would show how much the approach to allocation maintenance and rebalancing impacts performance.

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