By Stephen Hart
Learn more about Stephen on NerdWallet’s Ask an Advisor
What if I told you that I am a superior investment manager who’s had fantastic results: Last year my clients averaged a 2% return. That doesn’t sound that great — unless it’s 2009. In that case, my clients made money during one of the worst financial crises we’ve ever seen.
Without the proper context, it’s hard to gauge the success of your investment performance return. That’s why all portfolio strategies should have an appropriate benchmark against which you can evaluate them.
Think back to your high school science class. When you did an experiment, you always did a “control” test first. That was so you had a constant to compare different outcomes against. A benchmark acts in the same way.
Investment managers look for ways to create as much return as possible for clients, given their risk tolerance. A benchmark gives us a constant to compare a portfolio’s performance against. In some cases, we can use a pre-existing benchmark, but sometimes we need to create one specifically for a client. That’s because the right benchmark depends on how the money is invested — the type and mix of assets a portfolio contains and the investment strategy it follows.
For instance, with a portfolio consisting of only 30 U.S. large-capitalization stocks, the Dow Jones industrial average, which tracks the performance of 30 large U.S. companies, would make sense as a benchmark. But the Dow wouldn’t be a good fit for a diversified portfolio that mixes various investment types across different asset classes and markets around the world.
A benchmark must be a good fit for your portfolio to tell you whether it’s successful.
How to evaluate your benchmark
Ask your investment advisor the following questions to help make sure you understand your benchmark and to figure out if it’s right for your portfolio:
What is the benchmark we’ll use to gauge success, and why is it right for my portfolio?
Your portfolio should be evaluated against appropriately weighted indexes that closely resemble your portfolio’s construction. For example, a risk-adjusted, globally diversified portfolio shouldn’t be evaluated against the Dow, S&P 500, Russell 1000, Russell 2000 or any other broad index.
Say a portfolio is 40% bonds and 60% equity, and the equity is subdivided into 20% U.S. large stocks, 20% developed international stocks and 20% emerging markets. If the S&P 500, which is composed entirely of U.S. stocks, returns 10%, the portfolio would see a 2% boost rather than 10% — assuming all other sectors remain flat — because U.S. stocks make up only 20% of the portfolio. A manager would need to look at other benchmarks to gauge the success of the other segments of the portfolio, or compare the portfolio against a blended benchmark that incorporates all of them.
Did you create the benchmark or is it pre-existing?
Many large mutual fund companies provide pre-existing benchmarks for their funds. So do other companies, like investment research firm Morningstar. It’s much easier to track these kinds of benchmarks than it is to craft one specifically for your goals and risk tolerance. However, your advisor may have to create a blended benchmark that more accurately depicts the mix of investments in your portfolio.
Discuss with your advisor the pros and cons of each approach.
Given the objectives of my portfolio, what’s an appropriate time frame for comparison?
The time frame for evaluating your portfolio’s performance can vary greatly, depending on your investment strategy. It would make sense to evaluate a portfolio monthly if it’s aggressive and actively traded, because the manager will make short-term investment moves.
It would be hard to gauge relative performance of a more passive portfolio over a couple of years; it would need a longer term — say, 10, 15 or 20-plus years. It’s unlikely you’ll have to wait 20 years to see if your portfolio is working, but if you have a 20-year horizon, you may want to wait a few years before reading too much into its performance. Discuss these expectations with your advisor.
Is your goal to match or beat the benchmark?
This may seem a little silly. If you’re not trying to beat a benchmark, you could just buy low-cost index funds, which use passive strategies that track the components of an index like the S&P. Still, it’s best to ask and make sure you’re on the same page as your advisor.
How do you calculate portfolio performance?
There are several ways to evaluate performance. Two calculations you might use are a time-weighted return or a dollar-weighted return.
- A time-weighted return disregards the flow of money into and out of the portfolio, or cash flows. This calculation should be used to compare a portfolio manager’s performance to a benchmark, since it’s independent of whether an investor adds or withdraws money.
- A dollar-weighted return accounts for changing portfolio size due to cash flows. It may be more appropriate for goal-based planning since it shows the return on your dollars over time, including how adding or taking away money affects your overall wealth.
These two methods can provide vastly different results. Ask which one your advisor will use and write it down so you’ll able to tell if your advisor changes it or the numbers don’t seem to add up.
Missing the mark?
If your manager isn’t beating the benchmark, perhaps it’s time to part ways. If you do, though, you may be subject to capital gains taxes, transfer fees and a lot of headaches.
Before making a hasty decision, request a meeting with your advisor to discuss your options. Maybe you need to adjust your strategy, but maybe you need to give it more time. Be sure to ask questions to make sure you fully understand the benchmark and what it means for your investment performance. After all, it’s your money.
This article also appears on Nasdaq.