Many investors base the success of their portfolio solely on their annual rate of return, but you should also compare your return to a specific benchmark index.
What is an index?
An index is a statistical tool designed to measure performance over time.
Financial service companies create benchmark indexes then license them to investment companies to use as a measuring device for their funds, or as a basis for constructing various exchange traded funds and index mutual funds.
Indexes have been developed for all the main asset classes – cash, fixed income, stocks, real estate, etc. – as well as investment styles, and various regions and sectors.
There are thousands of different indexes. Here are some of the most well known for the Canadian investor:
- FTSE TMX Canada Universe Bond Index – broad Canadian government and corporate bond market
- S&P/TSX Composite Index – covers about 70% of companies listed on the TSX exchange
- S&P 500 Index – US large cap equities
- Russell 3000 Index – broad US stock market
- MSCI EAFE – large and mid-size companies in developed markets around the world (not including Canada and US)
- MSCI Emerging markets – equity markets in emerging market countries
New indexes are built regularly as new fund types are developed.
How indexes are constructed
Benchmark indexes are constructed in several different ways.
1. Market capitalization. This is the most common traditional method. The percentage of each stock is based on its market capitalization, or market value (the number of shares issued multiplied by the stock price). Market cap indexes tend to over-weight companies with large share issues and high prices which can greatly impact index performance,
Consider the S&P/TSX 60 Index which includes the largest and most traded Canadian companies. Canadian banks and natural resources account for almost 50% of the index. Small companies and certain sectors are not well represented.
Some indexes may modify this weighting by imposing limits on the size of any one holding – e.g. S&P/TSX Capped Composite Index weightings are capped at 10%.
2. Equal-weight. The characteristic of this type of index is that all holdings have the same weighting. It could have higher weightings in smaller stocks. e.g. S&P 500 equal weight index, BMP Oil & Gas equal weight index.
3. Factor based. Here, the intention is to improve traditional market cap indexes by choosing investments of a certain kind. These are sometimes called fundamental, alternative or smart beta indexes. e.g. FTSE RAFI US 1000 Index which is composed of top US listed companies chosen for their fundamental value – total cash dividends, cash flow, total sales and book to equity value.
Assessing portfolio performance using benchmark indexes
Benchmark indexes are used to evaluate the performance of your portfolio. Your portfolio should be compared to a benchmark that closely resembles the investments you own. A reference benchmark index may be included on your year-end investment account statement.
You can also create your own customized benchmark based on indexes for each of the asset classes you own.
Say your portfolio is a typical one that contains 20% Canadian large cap equities, 20% US large cap, 20% global equities, and 40% Canadian bonds, and you want to assess its performance over the past 5 years.
To create a suitable benchmark, you calculate 20% of the 5-year return for each of the S&P/TSX 60 Index, S&P 500 Index and MSCI EAFE Index, and then add 40% of the FTSE TMX Canadian Universe Bond Index.
The asset mixer at Norm Rothery’s website, Stingy Investor will do the math for you.
Benchmarks are most useful for evaluating longer-term investment returns.
Disadvantages on relying on a benchmark
When using a benchmark index to evaluate your investments, it’s important to remember that the index returns don’t include management fees, trading costs or administrative expenses. It would not be unusual for your portfolio to underperform its benchmark index due to these costs, so take that into account.
Sometimes the comparison can be misleading. If you have regular cash flow in or out of your portfolio, or make lump sum contributions or withdrawals, your rate of return probably will not be similar to the benchmark return. That’s because they are based on “time-weighted” returns where no additional money is added or withdrawn.