ITA Wealth Management

Much attention is given to market indicies as they are used to convey information as to how well a stock market is performing.  If someone says, the market is up or the market is down, they are generally referring to the Dow Jones Industrial Average (DJIA), an index that goes back to the late 1800s.

For our benchmark, we use the VTSMX index fund as it covers a wider range of investments than does the DJIA 30 stocks.  Rob Arnott writes in “The Fundamental Index” that “an index is a portfolio that is objective, formulaic, transparent, historically replicable, and has low turnover.”  The VTSMX meets the Arnott standard.

In addition to the VTSMX, the Mosaic spreadsheets also include the S&P 500 under the guise of VFINX.  You will also see something I call the “Blend Index,” an effort to see how closely the portfolio is tracking the ETFs and stocks that make up the portfolio.

Lowell Herr

Photograph:  U.S. time trials at Alpenrose - Portland, OR.

This information is available on the Premium Content side of this blog.  Cost is $6.99 per month.

Are there blog readers who would like access to a spreadsheet they can use to track portfolio performance as well as one of three benchmarks? If so, post your request in the comments section of this entry.  The spreadsheet I am referring to calculates the Internal Rate of Return for the portfolio and it does the same for the VTSMX benchmark as if one invested the same dollars in this index fund.  The spreadsheet also allows one to set up target percentages for asset classes of interest and then tracks the portfolio with respect to these asset allocation targets.

For more details as to using this spreadsheet, subscribe to Premium Content and watch the development of four portfolios. Those portfolios are; AA-Mosaic, Mosaic2, GLW, and Scrappy.

Lowell Herr

Photograph: Image taken on the Assawoman Bay (I kid you not) overlooking a sizable wetlands and on to the Ocean City, Maryland hotels. Visible is the water tower of OC and the famous pyramid hotel.

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

Setting up an appropriate benchmark for a portfolio is something I have been seeking for years. As yet, I have not found one, although I did come up with something I call a “Blend Benchmark” for the AA-Mosaic, Mosaic2, and GLW portfolios. Thus far the benchmark we are using to compare with portfolio results is the VTSMX index fund. However, the VTSMX is Vanguard’s Total Market Index fund and it does not represent our investments in REITs, commodities, international, and emerging markets.

How does one go about setting up an appropriate benchmark for portfolios as broadly diversified as the ones mentioned above? The “Blend Benchmark” is an effort to measure the performance of a portfolio vs. how well the portfolio would do had one been able to keep the portfolio exactly on target.

The “Blend Benchmark” takes the target percentage for each asset class in the portfolio and applies that target percentage against the actual ETF performance for that asset class. If the investor allows style drift or applies Tactical Asset Allocation (TAA), one can easily tell if the decision was a positive or negative move. All one needs to do is compare the portfolio performance vs. the “Blend Benchmark.”

Broker houses could easily provide this service to clients. To do so would encourage investors to begin to take a look at the asset allocation plan of their portfolio, the most important investment decision they will make. If you don’t recall how important, do a search for Ibbotson on this blog. Then look up Fama, French, and Brinson. Those entries should fill in the blanks.

Investors interested in seeing how the “Blend Benchmark” works are invited to subscribe to Premium Content.  The cost is $6.99 per month or about three cups of coffee.

Lowell Herr

Photograph: Experimental aircraft

If I were to make a recommendation to my security holding house it would go something like this.

• Set up the option to allow the investor to establish an asset allocation plan for their portfolio, much as we do in the spreadsheets for the AA-Mosaic and Mosaic2 portfolios.
• Establish appropriate benchmarks for the customer. This may be a combination of both equity and bond benchmarks or multiple benchmarks as determined by the target percentages assigned for each portfolio.
• Calculate the beta for each portfolio.
• Calculate the alpha for each portfolio.
• Calculate the sigma for each portfolio.
• From this data, determine the Information Ratio for each portfolio.
• Provide an easy method for merging multiple portfolios so one can measure the return of the portfolio compared to its appropriate benchmark.
• One should also be able to measure the alpha, sigma, Sharpe Ratio, R-Squared value, and Information Ratio for the merged portfolios.

While these requests may sound daunting, each broker house has the information to make these calculations for each and every customer.

What is in it for the security house? Why would they want to provide such a service? The bottom line is that any stock and bond security house could use the service to attract new customers. Further, such a service would help brokers work more effectively with their clients in planning and managing portfolios. Above all, the flexibility to manage portfolios in the manner would be a remarkable improvement over the current statements. 

I visualize customers establishing their own target limits just as we do in the Thomas/Lalla/Herr spreadsheet. When an asset class within the portfolio moves out of the target range, an e-mail reminder is sent to the customer warning them that one of their asset classes is out of balance. Note: It would be very important for each customer to have the flexibility to set their own target limits.

If there are like-minded readers out there, please comment on this modest proposal.

Lowell Herr

Photograph:  Your local “friendly” rodent.

Reporting on the Passive Portfolio is a regular event as this is one of the longest running portfolios I monitor.  As I recall, when I last reported on the performance results for this portfolio, the Internal Rate of Return (IRR) was 3.4% points higher than the VTSMX benchmark.  When the portfolio performance is outstripping the benchmark I know I will end up with a positive Information Ratio.  But by how much is the next question.

To keep track of the Passive Portfolio, I keep records using a software program called Captool.  Unfortunately, this software is no longer supported by the company so I am running on borrowed time with this program.  However, it is the only affordable program I know of that will calculate the Alpha and Sigma for a portfolio.  In addition, I use the Thomas/Lalla/Herr spreadsheet to give me accurate portfolio and benchmark performance results.  From Captool and the SS, I am able to glean accurate records on this portfolio.

As of 7/31/2008, the Passive Portfolio is generating a remarkable Information Ratio of 0.87.  I will put that number up against almost any money manager except the combination of Buffett-Munger.  The portfolio did lose over 10% during the last two months, a devastating blow.  Looking back over the nearly eight year record, the portfolio outperformed its VTSMX benchmark over every period examined.  That includes five-, three-, two-, and one-year periods.  This last year has been one of the most difficult for this portfolio.

The PP experienced approximately two trades per year due mainly to selling stocks contributed to the endowment fund and we did rebalance once or twice since inception.  Also, we will reinvest dividends when they grow to a sufficient percentage so as to keep commissions to a minimum.  The portfolio is skewed slightly to the value side of the equities spectrum.  This portfolio tilt was definitely the way to lean over the last eight years.  One never knows if this will change over the next five to ten years.

If anyone has questions as to the asset allocation percentages, just ask and I will try to answer all probes.

Lowell Herr

Photograph:  Carving by Howard Tibbals.

After six months of operation, the AA-Mosaic Portfolio is doing very well on a relative basis. Here are the Internal Rate of Return (IRR) figures. All the transaction details are available on Premium Content. Access to the spreadsheet shows how the assets are allocation.

• AA-Mosaic Portfolio -7.4% IRR
• VFINX Index - 18.8% IRR
• VTSMX Index - 16.8% IRR
• VGRSX Index - 18.6% IRR

While all IRR values are negative, due in large part to a poor market in June, the portfolio is performing significantly better than the primary benchmark, VTSMX.

Premium Content available for $6.99 per month.  Register now.

In light of the recent development of the “Blend Benchmark,” a long quote from Mark Hebner’s book is appropriate. I am pulling this information from pages 106 and 107 of the “Index Funds” book.

“There are at least three problems associated with manager picking. For one thing, investors are seldom aware that active funds or separate portfolios that have good performance histories are always riskier than the indexes they outperform. According to the Modern Portfolio Theory, any portfolio of investments that hold fewer stocks than the index in which it is invested must be, by definition, underdiversified relative to that index portfolio. It follows then that any mutual fund or separate portfolio that has turned in a market-beating performance achieved it by holding investments that somehow were different in kind or amount from those of the relevant index. Any mutual fund or separate portfolio that boasts a superior performance history must therefore be riskier.”

“A mutual fund manager with recent performance success has bet money and concentrated it in specific stocks or bonds. The bet may pay off, but people are too blinded by the “brilliant investment insight” to understand that the bet was too risky in the first place. Peter Lynch, the legendary manager of Fidelity’s Magellan mutual fund, concentrated about 25% of the fund’s holdings in foreign stocks in the 1980s. These stocks turned out to be top performers, and Magellan widely outpaced the S&P 500. The irony is that these stocks weren’t even represented in the S&P 500.”

The Blend Benchmark was developed in order to properly account for taking on additional portfolio risk.

This discussion will continue later today or tomorrow over on the Premium Content side of the blog.

Lowell Herr

Photograph:  Diamond Head, Hawaii

The “Blend” benchmark one now sees in the AA-Mosaic and Mosaic2 portfolios is designed to overcome inherent problems with benchmarks such as the S&P 500 (VFINX) or Vanguard’s Total Market Index Fund (VTSMX). These benchmarks fall short of what they are intended to measure for two reasons. 1) Both the VTSMX and VFINX focus on a narrow section of the market when compared to the broad diversity covered by the two portfolios. For example, the portfolios move into international, REITs, commodities, and emerging markets. Neither benchmark adequately encompasses these asset classes. 2) Both VTSMX and VFINX are weighted toward large-cap stocks and our portfolios lean toward mid-cap and small-cap asset classes.

For these reasons, the VTSMX and VFINX benchmarks are inadequate. Hence the effort to come up with the “Blend” index. Here is how it works. We take the percentage allocated to a particular asset class and multiply that percentage times the actual IRR performance value for the asset class. Then we sum all asset classes to come up with the performance of a portfolio if we held the exact target percentages. This is an effort to come up with a better benchmark and one that reflects the wide diversity exhibited in these portfolios.

The goal of any portfolio is to beat an appropriate index.  I conclude that the VTSMX, while a useful benchmark, lacks the coverage required for the AA-Mosaic and Mosaic2 portfolios.  Over time we will see which of the four benchmarks now included in the spreadsheets provide the highest bar to hurdle.

Please raise questions in the comment section.

Lowell Herr

PS  Access to the spreadsheets is available through Premium Content.

Photograph: Peru - Overlooking a section of the Sacred Valley

Bill Miller is touted as the only active mutual fund manager to outperform the S&P 500 for 15 consecutive years. Check out the article at this location. It is a remarkable record for an active manager. But what about that old pesky index fund, VFINX. Check the comparison here on Yahoo. Look closely at that percentage difference over on the right. It appears as if VFINX comes in around 325% and LMVTX show up around 225%. It looks like the index wins again.

Welcome to the first full day of summer!

Lowell Herr

Photograph: Coffee cup from an outstanding software/hardware company in Oregon.