Choose The Right Benchmarks

Special Investment Management Article For Licensed Investment Professionals Only
(Educational Purposes Only)
This is the first in a series of articles discussing how to beat the benchmarks.  In this article, we will discuss the importance of setting appropriate benchmarks and providing the proper focus.
Before we begin a discussion about how to choose the right benchmarks, it is important to keep things simple.  If you are going to invest in different asset classes, use a variety of benchmarks rather than a single benchmark.

Most investors have a default benchmark.  If you are an American investor, you will likely be targeting the S&P 100 or S&P 500 indices as your benchmark.  If you are a Canadian investor, the TSX 60 index is likely your default benchmark.

Others focus on a blended benchmark.  For example, let’s consider an investor with a diversified portfolio that contains US equities, Canadian equities and bonds.  Most advisors simply choose their default benchmark, so a Canadian advisor uses the TSX 60 as the benchmark.  More sophisticated advisors would create a custom benchmark that blends the three asset classes (40% S&P 500, 40% TSX 60, 20% Bonds).

Choosing the correct benchmark is an important first step in the Beat The Benchmark process.  Blending benchmarks may sound simple at first and will work well if you are taking a static asset allocation approach but what if you decide to over weight US equities and shift your asset allocation to 50% US equities, 30% Canadian equities and 20% Bonds?  Do you then change your benchmark?

If you are going to have an asset class diversified portfolio, you are best to have specific benchmarks for each asset class.  If your focus is to beat each of the three benchmarks listed above, the process will be much more focused and easy to track.

Benchmark Selection
Indices, like the S&P 500 or the TSX 60, are simple to use but there are a few things to consider if you choose to use them.  The first question is “Is this an appropriate benchmark?”  If you are investing in a diversified portfolio that can include high percentages of cyclicals, like metals and mining and energy, the TSX 60 is a great benchmark.

If you are managing a low volatility portfolio, the TSX 60 (36% Financials, 21% Energy, 10% Materials) would be a poor benchmark.  If we experience great performance in cyclical stocks, as we did in the early 2000’s, your low volatility strategy would have under performed the TSX 60 from 2000 to 2008.  On the other hand, since 2008, your low volatility strategy would have out performed the TSX 60.  If your goal is to beat the benchmark, you can set yourself up for failure by choosing the wrong one.

I like to build customized benchmarks for strategies for stock selection.  In a future article, I will discuss building fundamental “sandboxes” as a first step in the BTB process.  Let’s say that you build a low volatility sandbox of 50 companies.  The equal weighted composite return of this sandbox would be a great sandbox.  In some cases, you can find an ETF that will do the job.  For example, ZLB.TO is made up of 50 stocks with the lowest volatility, selected from a basket of 100 of Canada’s largest companies.

That would be a great benchmark for your strategy as well as a resource for identifying stocks for your sandbox.

ETFs make Great Benchmarks

I never use indices as benchmarks.  In most cases, they do not include dividends, so although it is easier to beat the indices, we should make it more difficult rather than easier.  If you have a stronger benchmark, only stronger stocks will be able to make it through your screen and this should enhance performance.

IVV or SPY, for US markets, and XIU, for Canada, do include dividends in their performance numbers.  If you are managing a low volatility portfolio, choose a low volatility ETF, like ZLB or if you are managing a mid cap growth portfolio, look at something like CDZ (Canadian Dividend Aristocrats).

Focus Is An Important Factor In Beating The Benchmarks
Unless you give your project of beating a benchmark the necessary attention, your chances of winning are slim.  I do find it funny that although approximately 50% of stocks in an index out perform an index,  only 30% of investment managers are capable of achieving this goal.

In most cases, advisors do not give the project of beating the benchmarks sufficient attention.  Intuitive investing has a poor track record of beating the benchmarks.  Working with unstructured and unfocused portfolios or too many clients with different portfolios also have a poor track records.

It is similar to playing golf and not keeping score.  If your goal is to break 80 or even 100, it takes focus.  Fortunately in golf if you fail to break your target score, you can try again tomorrow without consequences.  In portfolio management, you are playing with your clients’ financial futures, the value of your book and the revenue of your business.  Failure to beat the benchmarks affects many things.