ITA Wealth Management

Below you will find six requirements for setting up a benchmark for a portfolio. These six guidelines are modifications of ones I picked up from Rick Ferri. You will recall me recommending several of Ferri’s books on this blog. His latest one is on ETFs, and I consider it required reading for anyone using ETFs to build a portfolio.

Here are the six benchmark standards one should apply when developing a method for measuring portfolio performance.

Investable: One should be able to invest in the benchmark. For example, instead of using the S&P 500 as the benchmark, use the VFINX as one can actually invest in this index mutual fund. There are several reasons for using an investable index. 1) Dividends can be tracked accurately. 2) The bid/ask slippage is taken into account. 3) Fees and expenses are factored into the performance of the index providing a better comparison with the performance of the portfolio.

Appropriate: This aspect of benchmarking is one that is consistently violated by money managers, trustees of endowment funds, and individual investors. It is not unusual for an investor to say they are beating the market, only to find out they are using the S&P 500 as their benchmark. This might be an appropriate index if the portfolio consisted of large-cap stocks. But what if the portfolio also includes commodities, emerging market equities, REITs, and bonds. If the portfolio is broadly diversified, the S&P 500 is not an appropriate benchmark. The need for an appropriate benchmark is vital when it comes to measuring portfolio performance.

Informed Opinion: One needs to be able to explain what investments are included in the benchmark and are the percentages that make up the benchmark aligned with the asset class target percentages in the portfolio. For example, if one targets 10% of the portfolio to small-cap value (SCV), does the benchmark include an index with 10% in SCV. The performance of the portfolio with respect to the appropriate benchmark needs to be explained and understood.

Unambiguous: The benchmark needs to be clearly defined, transparent, and easily understood. It is important that the weight of each index within the benchmark is assigned properly and matches the asset class target percentages. The “Blend Benchmark” does this. For example, if 10% of the portfolio is allocated to mid-cap growth, then a benchmark that includes 10% in VOT (Vanguard’s mid-cap growth ETF) should be part of the index.

Specified in Advance: The benchmark need to be selected or constructed in advance or at the time of the construction of the portfolio. The benchmark should not be altered in a way so as to make the portfolio look good with respect to the benchmark.

Proper Handling of Cash Flow: The benchmark needs to accurately handle the cash flow issue in order to make an accurate Internal Rate of Return calculation. Most, if not all reasonably priced commercial software fails this test. When new cash is deposited or withdrawn from the portfolio, these cash exchanges need to be recorded for the benchmark so there is a one for one comparison. Sloppy record keeping frequently overlooks what happens within the benchmark. The Thomas/Lalla/Herr spreadsheet calculates the benchmark cash flow properly.

Lowell Herr

Photograph: Amish country in Pennsylvania