Investing can be a challenging endeavor, and one key aspect of successful investing is benchmarking. Benchmarking is the process of comparing the performance of your investment portfolio against a specified benchmark or set of benchmarks. By benchmarking your portfolio, you can determine whether your investments are performing better or worse than the market and make informed decisions about whether to adjust your investment strategy.
In this post, we will cover topics such as how to choose relevant and investible benchmarks, creating a blended benchmark for your entire portfolio, using portfolio management software, and constructing indexes for asset categories without traded benchmark ETFs. We will also discuss how to track and report on portfolio performance, and the benefits of doing so in-house instead of relying on 3rd parties.
Whether you’re an individual investor or part of a single-family office, this post will provide valuable insights into how to benchmark your investment portfolio.
What is benchmarking?
Investment benchmarking is the process of comparing the performance of an investment portfolio or an investment strategy against a specified benchmark or a set of benchmarks. The benchmark could be a market index or a group of securities that represent an asset class, sector, or region.
Why Benchmark a Portfolio?
The purpose of investment benchmarking is to evaluate the performance of the portfolio or investment strategy against a relevant standard. This helps investors to understand whether their investments are performing better or worse than the market, and to make informed decisions about whether to adjust their investment strategy.
For example, an investor with a portfolio of US stocks might benchmark their performance against the S&P 500 index, which is widely regarded as a benchmark for the US stock market. By comparing the performance of their portfolio against the S&P 500 index, the investor can determine whether their portfolio is outperforming or underperforming the market (also known as Alpha).
How to Choose Benchmarks
When choosing investment benchmarks, they must be both relevant and investible.
First, the benchmarks you choose must be “relevant”. This means, they must represent the same asset class or type of investment that you’re trying to benchmark. For example, if you’re benchmarking US stocks, then you might choose the S&P 500 Index.
Second, the benchmarks you choose must be “investible”. This means, they must be practical alternatives to the investments you’ve chosen, not simply theoretical possibilities. For example, many benchmarks are ETFs because they often represent practical ways to invest in relevant indexes.
A Benchmark for Each Asset Class
Its generally a good practice to choose a relevant benchmark for each asset class in your portfolio. This allows you to evaluate the performance of each asset class relative to its respective benchmark and help you identify areas where your portfolio may be over or underperforming.
A Portfolio Benchmark
Once you’ve chosen a benchmark for each asset class in your portfolio, Investors can create an aggregate benchmark for their entire portfolio by combining the benchmarks for each asset class based on their portfolio weight. This approach is known as a blended benchmark.
Here are the steps to create a blended benchmark:
- Determine the asset class weight: First, you need to determine the weight of each asset class in your portfolio. You can do this by calculating the percentage of your portfolio that is invested in each asset class.
- Select benchmarks for each asset class: Choose a relevant benchmark for each asset class in your portfolio, as discussed earlier.
- Calculate the weighted average return: Calculate the weighted average return for each benchmark by multiplying the return of each benchmark by its respective asset class weight.
- Combine the weighted averages: Finally, combine the weighted average returns for each benchmark to create an aggregate benchmark for your entire portfolio.
For example, let’s say your portfolio is made up of 60% stocks and 40% bonds. You use the S&P 500 index (represented by the Vanguard S&P 500 Index ETF) as the benchmark for your stock holdings, and the Barclays Aggregate Bond Index (represented by the iShares Core U.S. Aggregate Bond ETF) as the benchmark for your bond holdings.
To create a blended benchmark for your entire portfolio, you would calculate the weighted average return for each benchmark based on its asset class weight. Let’s assume the S&P 500 index has a return of 10% and the Barclays Aggregate Bond Index has a return of 5%:
- Weighted average return for stocks = 10% x 0.6 = 6%
- Weighted average return for bonds = 5% x 0.4 = 2%
- Combined weighted average return = 6% + 2% = 8%
Therefore, the blended benchmark for your entire portfolio would be 8%. You can then compare the performance of your portfolio against this blended benchmark to evaluate your overall investment performance.
Portfolio Management Software
Wealth management firms and multi-family offices (“MFOs”) have the scale and resources to use portfolio management software to benchmark their returns. These firms typically use software such as Advent, Eton, or Addepar.
The downside for clients of these firms is they will have limited capacity to customize their reporting. This is the primary way wealth management firms achieve scale: they force their clients to follow their standardized wealth management process.
This is one of the benefits and costs of being an individual investor or single-family office. You get to customize your benchmarking & reporting, but you also must do the work yourself (or pay your family office to do it for you).
Portfolio management software that will provide benchmarking is prohibitively expensive for individual investors. So, whether you’re an individual investor or single-family office, you’re probably forced to rely on Excel & Sheets.
Portfolio Tracking Apps and Benefits of Customizable Spreadsheets
Although there are many portfolio tracking apps available today, most lack the ability to provide customized reporting and benchmarking. Most are also unable to track private equity and other non-traded assets, or integrate with bookkeeping software such as Quickbooks or Xero.
In the end, sophisticated investors will probably find they can get more done at a much lower cost by building their own benchmarking and reporting platforms using Excel & Sheets.
Practical Benchmarking Example
Suppose an investor holds a substantial investment portfolio, which includes their family foundation, and they engage a single-family office to help them benchmark their results.
The benchmarking process begins with the investor collaborating with their wealth advisor to establish their investment objectives and core values. Once the advisor creates an investment policy that outlines relevant topics such as risk tolerance, time horizon, and asset allocation, the investor uses it to guide investment decisions.
Based on this exercise, the investor decides to construct an investment portfolio that includes 60% US equities, 10% Canadian equities, 10% real assets, 10% values aligned (impact), and 10% term deposits & cash.
How do we benchmark this portfolio?
Choosing a benchmark for US & Canadian equities is straight-forward since there .
If the portfolio supports ESG values, the iShares ESG Advanced MSCI USA ETF (symbol USXF) can serve as the ESG benchmark for US equities. The iShares ESG Advanced MSCI Canada Index ETF (symbol XCSR) can serve as an ESG benchmark for Canadian equities.
To benchmark cash and other deposit rates, simply use a relevant benchmark rate such as the rate on the High Interest Savings Account (“HISA”) the portfolio uses.
Creating Benchmarks for Asset Categories Without Traded Benchmark ETFs
When an investment portfolio’s asset allocation includes categories that lack traded benchmark ETFs, benchmarking can become more challenging. For instance, in our case, the “real assets” and “impact-aligned” categories cannot be benchmarked using ETFs. So, to establish benchmarks for these categories, the investor’s wealth advisor must create blended benchmarks for this arbitrary asset class. To provide a clearer picture of how this process works, let’s examine the contents of the “real assets” and “values aligned” categories for our hypothetical investor.
Constructing Indexes for Asset Categories Without Traded Benchmark ETFs
Inside the “real assets” category, the investor intends to invest in a mix of both public & private renewable energy companies and values aligned real estate. So, our benchmark for this asset class could consist of 50% Renewable Energy Producers ETF (symbol RNRG) and 50% iShares Core U.S. REIT ETF (symbol USRT).
For the “impact” section of the portfolio, the investor wants to invest in revenue generating private companies and venture funds that support the values outlined in the investment policy. To benchmark the returns of this asset class, the investor has decided that any economic return above zero is the goal. So, in this case our benchmark is zero.
Tracking Performance of our Blended Benchmark
Now we have a benchmark for each asset class in the investor’s portfolio as follows:
- 60% iShares ESG Advanced MSCI USA Index ETF (US equities)
- 10% iShares ESG Advanced MSCI Canada Index ETF (Canadian equities)
- 10% half Renewable Energy Producers ETF / half iShares Core U.S. REIT ETF (real assets)
- 10% return of capital (zero percent return goal) (values aligned impact)
- 10% relevant HISA (cash)
To calculate the blended benchmark, simply find the weighted average return as described earlier.
Using a Spreadsheet for Benchmarking
The family office of the investor must maintain a spreadsheet specifically designed for performance reporting to track the value of each investment and benchmark during each period (typically monthly), including any distributions received from each one.
With the performance data for each investment and benchmark in a spreadsheet, the investor’s family office can then use the IRR method or a modified Dietz method to calculate rates of return for benchmarking purposes.
Our Family Office
One of the main benefits of our family office is we bring independent and customizable performance reporting to our clients. When we were working with a Canadian bank owned brokerage, we got stuck using their reports. Which did not often illustrate the true nature of a client’s portfolio. But, as a family office we are free to create reports for our clients that reflect our clients own desires.
If you have further questions about performance reporting and benchmarking, please feel free to get in touch with us by clicking here.
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