Model portfolios: Benchmarking performance Pt 1

Before explaining how we'll monitor our model portfolios, we explore some of the problems with traditional benchmarking.

Key Points

  • Benchmarks are more about the managers than the investors
  • Indices contain flaws which reduce their usefulness as a benchmark for real-life portfolios
  • If you’re going to compare to an index, you'll need to make some adjustments

If you’re a Star Wars fan you’ll know about ‘Jedi mind tricks’. A wave of the hand, a soothing voice and the Jedi Master has you in under their control. In finance, one of the great Jedi mind tricks is the art of ‘benchmarking’, which can determine whether your adviser or fund manager is a hero, or not.

Benchmarking is the practice of comparing someone’s investment performance to an independently calculated index like the S&P/ASX 200. It's something we've thought a great deal about in creating and managing our ASX 200 'Total Return' Index (also referred to as the Accumulation Index). You'll beat the ASX 200 Price Index simply because you've got dividends and franking credits included.

  • Add-back franking credits. Our colleagues at Share Advisor compare their model portfolios’ performance to a ‘franking adjusted ASX 200 Total Return index’. In essence, they add an estimate of what the franking credits would be on a portfolio mirroring the ASX 200.
  • Risk adjustment. If you’re particularly targeting a low or high-risk portfolio, why compare your performance to a ‘random risk’ portfolio? We're not suggesting getting too scientific about this, but you should expect a boring portfolio to slightly underperform the index in the 'good times' and slightly outperform in the 'bad'. If you're taking on a lot of risk and only matching the ASX 200 performance, that might be a sign to worry.
  • Specific objectives. In correlated with the various resource stocks driving the market performance. Fortunately, there's an S&P/ASX 200 Resources Index, so you can subtract it's contribution to the ASX 200 performance and compare to what's left.
  • Just be careful not to benchmark too often.

    The question of timeframe

    Indices encourage ‘short-termism’, especially among fund managers who report their performance monthly. They may talk about long term but a manager that underperforms the ASX 200 month after month may not last to see it.

    Individuals face ‘career risk’ (the risk of losing their job) so it can be tough to make sensible decisions over a long-term that may stretch well beyond the day they walk out the door. It’s hard for a fund manager whose performance hovers around the index to lose their job, even though it may cost investors a fortune in long-term returns.

    Career risk helps explain why so many large funds effectively end up as ‘index-huggers’. Keeping a portfolio close to the index weightings makes it difficult to go too far wrong, but it reduces the chance of getting it right.

    That's a problem for investors, as we'll explain in Part 2 when we tackle our own model portfolios.

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