Your investment goal should be to earn positive returns, don’t fall into the benchmarking trap, writes Landon Whaley.
According to the Index Industry Association’s (IIA) latest report, 770,000 benchmarks are getting the “Old Yeller” treatment this year, which still leaves an astounding 2.9 million financial market benchmarks worldwide! To put this number in perspective, there are only approximately 630,000 stocks globally, with just 2,800 of those on the New York Stock Exchange and another 3,300 trading on the Nasdaq. Calculating the “benchmark-to-individual stock” math tells us there are five times as many benchmarks as there are stocks in circulation. Wow.
Frankly, these numbers are astonishing, and I’m inspired to discuss benchmarking, the practice of comparing a portfolio’s returns to the returns of an arbitrary benchmark of stocks, bonds, and the like. Benchmarking has been an Old Institution tradition since the index was first created, but it’s an incredibly ineffective way to determine if an asset manager has skill or is just riding the fact that markets naturally drift higher over time. But we’ll save that discussion for another day because this week I want to coddiwomple through the fact that this benchmarking concept has made its way to the individual investor in a big way and is doing those investors a great disservice.
It seems that everyone is comparing their portfolio returns to that of an index like the S&P 500 or an indexed portfolio metric like 60/40 to ascertain if they should be happy or sad with the returns they earned. Who cares how your portfolio did against the S&P or a 60/40 mix of U.S. stocks and bonds? Are you ever going to have 100% of your portfolio in U.S. mega-cap stocks? I certainly hope not, so get rid of the S&P 500 comparisons. Are you ever going to statically allocate 60% of your portfolio to U.S. mega-cap stocks and the other 40% to U.S. bonds? If you believe (and you should) that the prevailing Fundamental Gravity drives the risk and return of asset classes, then your answer is a resounding no!
There are times to be invested in certain asset classes and times to steer clear of them, which makes this “relative to an index” performance game a non-starter. While these measures are necessary, even essential, to portfolio managers who have specific mandates to meet or beat specific benchmarks, they should not matter to the rest of us. For us, there is only one way to evaluate portfolio returns: net absolute returns. Net means the gains you’ve earned after all commissions, fees, taxes, and the like. Absolute means that regardless of economic or market conditions, did you earn a positive rate of return over the time frame you’re evaluating?
For example, since U.S. growth peaked in Q3 2018, there is only one question that needs answering: did your portfolio make money after fees and taxes?
Since Oct. 1, 2018, the S&P 500 has done reasonably well, gaining 8.2% but with a steep 19.2% drawdown to boot. The Old Institution’s 60/40 portfolio metric has done slightly better gaining 9.0%, but it too had a double-digit (-11.0%) peak-to-trough move over that time frame. Remember, not all returns are created equal. The S&P 500 is delivering an R-2-R of 0.43 while the 60/40 is giving you an R-2-R of 0.81. Are you happy with single-digit returns and double-digit drawdowns that equate to more downside risk than profit potential? The Old Institution (and anyone else benchmarking portfolios) will tell you that’s par for the course. However, I can tell you that if you have a dynamic and multi-factor process, above-average, risk-adjusted returns can be had every year. In short, you can flip the script above and earn double-digit gains while experiencing only single-digit drawdowns.
Leave benchmarking to the Old Institution and its followers. Building an absolute return process is the only way you can keep the “Hi, welcome to Walmart” risk at bay.
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