How to Benchmark Your Portfolio

What is the best way to measure your portfolio’s performance? Comparing starting and later portfolio values over a select period of time? Or how your performance squares with someone else’s, like your neighbour’s? Whilst these approaches may seem logical, we think they have holes. In our view, comparing your performance to an appropriately diverse measure of the market makes most sense. In industry parlance, we call this selecting an appropriate benchmark—an equity or fixed interest index (or blend of the two) you’ll use as a comparative tool. Done correctly, benchmarking can help you better navigate markets on your journey to your investment goals. Here is how to do it.

A benchmark is an index of investments you can track in asset classes like equities, fixed interest or others. It provides a framework to help construct your portfolio, manage risk and track returns. A benchmark also acts as a guide and comparison point for realistic returns based on evolving market conditions—helping set investors’ expectations.

But selecting any index won’t do. Critically, we think your benchmark should first and foremost align with your asset allocation (your portfolio’s mix of equities, fixed interest and other assets)—which is directly related to your personal investment goals and objectives. That asset allocation should reflect the return you need to reach your goals—and your comfort level with the risks associated with achieving that result. Your benchmark should therefore be an index reflective of your portfolio’s composition. For example, if your portfolio holds fixed interest, your benchmark shouldn’t be a 100% equity index. Doing so compares apples and oranges. Rather, we see it as more apt to blend equity and fixed-interest benchmarks in accordance with your asset allocation’s share of each.

Generally speaking, choosing a broad, globally diversified market index is sensible for many long-term, growth-oriented investors. Global benchmarks aren’t overly concentrated in any one country, sector or company, helping investors avoid taking too much risk in a single part of the market. Taking a global approach is difficult for many investors to fathom, especially as many tend to be biased to their home countries, in our experience. But local equity markets often skew heavily towards a handful of sectors or even individual companies—subjecting investors to potential concentration risk.

This is the case for many European markets. Take Norway, where 5 of 11 global equity sectors—Energy, Financials, Consumer Staples, Communication Services and Materials—comprise the entirety of the market.ⁱ In Denmark, a single Health Care company accounts for nearly 40% of the domestic equity market.ⁱⁱ Even big nations can have large concentrations in relatively narrow areas. In Europe’s biggest economy—Germany—the Automobile, Chemicals and Insurance industries’ market capitalisations far exceed their weight in global markets.ⁱⁱⁱ When these categories are in favour, Germany often will outperform broader markets and appear more attractive to investors. But no one category leads for all time, and leadership often rotates during the market cycle. Choosing a geographically diversified benchmark that isn’t overly concentrated in a few sectors or individual companies gives you more opportunities to effectively diversify—a plus.

Some index constructions are better than others, too, in our view. For example, we think market-capitalisation-weighted indexes are superior to price-weighted indexes. Market-capitalisation-weighted indexes—companies’ share price multiplied by number of shares outstanding—reflect companies’ size. Firms with larger market capitalisations will correspondingly have greater influence on the index’s movement. Contrast that with price-weighted indexes, where a security’s share price determines its weighting in the index (e.g., America’s Dow Jones Industrial Average or Japan’s Nikkei 225). That construction makes little sense, in our view, as share price alone doesn’t reflect the company’s actual market value.

Besides an index’s construction and makeup, check whether it has an established history—enough to give you an idea of its returns through several market cycles. Now, this won’t tell you what the future holds—no backward look at history will. However, it does offer a reasonable basis for setting expectations, given a long-enough history of reliable data.

Once you have a benchmark, analyse its components. They will give you a high-level guide as to how you should roughly position your portfolio—what geographies and sectors to own and by how much. Your portfolio may differ from the benchmark, but it should be intentional, in our view. For example, let’s say you expect Financials shares to lead, and your benchmark is the MSCI World. Financials have about a 16% weighting in the MSCI World.^iv Hypothetically, you can increase your Financials holdings to roughly 20% or 21% based on your outlook, but your benchmark allows you to appropriately size those opportunities so you don’t take too much risk—in case you are wrong! Then, you can measure the performance difference. You will have a better sense of how well (or poorly) your investment decisions impacted returns. This is how many professional money managers invest—a far more realistic and grounded way to approach markets and assessing performance than just looking at numbers in isolation, in our opinion.

Benchmarking your portfolio allows you a clearer way to see where you are taking measured risks. It gives you a roadmap that can help you achieve your long-term financial goals and give you a measuring stick for how well you are doing along that path.

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