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Build your own benchmark

Traditional benchmarks have a purpose, but they are impersonal and fail to reflect the messy realities of investing.

Ben Johnson, CFA 4 March, 2016 | 6:00PM
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How do you track your progress toward your financial goals? How do you assess your abilities as the manager of your personal portfolio? How do you measure the value of a trusted advisor? Do you have a benchmark? If your answer is no, then you may want to consider building one.

Benchmarks play a central role in performance evaluation. They serve a "you are here"-type function that allows us to assess the state of the markets as well as the relative performance of the various "helpers" (to borrow a term from Warren Buffett) that we've hired to aid us in investing our precious capital with an eye toward meeting our financial goals.

On a stand-alone basis, any given financial index has limited utility. The S&P/TSX Composite Index can tell us a lot about how blue-chip Canadian equities are performing or how an actively managed large-cap stock fund is faring relative to the market at large, but it gives little insight into the performance of a globally diversified portfolio of stocks, bonds and other asset classes, and less still into how this portfolio is progressing toward meeting one's goals. In isolation, an index is inherently impersonal and sterile.

Of course, it is simple enough to combine multiple indexes, each representing distinct asset classes, in a mix that mimics an asset allocation aligned with an investor's goals and willingness and ability to assume risk. Such a blended benchmark is inherently more representative of an investor's true experience than a single-asset-class yardstick in a vacuum. However, even a custom solution like this still falls short.

A blended benchmark fails to account for the messy reality of investing--most notably, costs. Indexes do not adequately capture the effects of fees, investors' specific tax circumstances, or the cost of advice.

Low-cost index mutual funds and exchange-traded funds covering an ever-expanding array of broad asset classes and niche strategies have proliferated over the past two decades. This trend has coincided with widespread technology-driven deflation that has driven down trading costs and is increasingly pressuring the cost of advice by automating asset allocation and fund selection. These trends have made it possible for investors to build and invest in their own custom "benchmark" in a matter of minutes. I think that there is a massive amount of value that can be realized by allocating a token amount of one's financial capital to such a portfolio.

A real-money bespoke "benchmark" is as useful a guidepost as anyone can likely build. Investors can employ such a portfolio to assess their own investment decisions, the value of the decisions that other "helpers" (portfolio managers, advisors and so on) are making on their behalf, and their progress toward their financial goals. I believe that this sort of construct has more merit than a blended "paper" benchmark in that it 1) will inherently reflect all the various costs listed above, and 2) is seeded with real money. Having a real-money portfolio as a benchmark, no matter how small the amount, has the benefit of making the opportunity costs (essentially, the performance of your benchmarked portfolio minus the performance of the "benchmark") more fungible.

The makings of a good benchmark

What makes a good benchmark? In the book Managing Investment Portfolios: A Dynamic Process, the authors describe a good benchmark as follows:

In practice, an acceptable benchmark is one that both the investment manager and the plan sponsor agree represents the manager's investment process. However, in order to function effectively in performance evaluation, a benchmark should possess certain basic properties. It should be:

Unambiguous. The names of securities and their corresponding weights in the benchmark should be clearly noted.

Investable. The benchmark should be available as a passive option.

Measurable. It should be possible to calculate the benchmark's return on a timely basis, for various time periods (e.g., monthly, quarterly, annually).

Appropriate. The benchmark should be consistent with the manager's investment style or area of expertise.

Reflective of current investment opinions. The manager should have opinions and investment knowl¬edge of the individual securities within the benchmark.

Specified in advance. The benchmark should be speci¬fied prior to the beginning of an evaluation period and known to both the investment manager and the fund sponsor.

Owned. The investment manager should be aware of and accept accountability for the constituents and performance of the benchmark.

A portfolio of low-cost index funds and/or ETFs designed to fit an investor's specific goals and circum¬stances ticks all of these boxes. Furthermore, it is fully investable, can be quite literally owned, and as such will reflect all the associated costs of initial investment and ongoing ownership. Now that I've hopefully convinced you that this isn't a completely cockamamie idea, I'd like to cover some specific means by which you can actually build your own benchmark.

Today it is easier and cheaper than ever to BYOB

Technological advances have made it easier and cheaper for investors to build their own benchmark. There are a variety of different ways to do it. Here I share three of the lowest-minimum-investment, lowest-cost, lowest-maintenance options available.

1) An age/target retirement-date-appropriate index-based target-date fund.
Phillips, Hager & North's LifeTime series of target-date funds have a $500 minimum investment, invest in a wide range of PH&N and RBC funds, and their asset allocations are actively managed and regularly rebalanced by the funds' managers. They are the only retirement-focused series to be available in Series D, which pay reduced trailing commissions to the fund dealer, and so their management-expense ratios are among the lowest in Canada, ranging from 0.90% to 1.36%.

+ Pluses: This is a very low-minimum-investment, low-cost, low-maintenance option for a personal benchmark.

Minuses: A target-date fund is most appropriate for benchmarking one's progress toward retirement-related goals. It isn't as useful for purposes of benchmarking one's progress toward other major financial milestones.

2) A three-ETF portfolio.
Investors can get broad, uber-low-cost exposure to domestic and foreign equities, as well as investment-grade Canadian bonds by combining iShares Core MSCI All Country World ex-Canada (XAW) (0.21% expense ratio) Vanguard FTSE Canada All Cap (VCN) (0.06% expense ratio) and Vanguard Canadian Aggregate Bond (VAB) (0.14% expense ratio). The appropriate mix would, of course, depend on an individual's specific circumstances. At present, a 70/30 stock/bond mix, with a 20% Canadian stock content, would currently consist of approximately three shares of XAW, two shares of VCN and seven shares of VAB, for a total price of about $270 and an asset-weighted fee of around 0.14%.

+ Pluses: This approach is nearly as simple and inexpensive as it gets.

Minuses: There is a minor amount of up-front homework and ongoing maintenance required in this approach with regards to determining and subsequently rebalancing to one's target allocation. Some might consider it to be overly simplistic or inadequately diversified. Depending on the investor's discount brokerage firm, transaction costs may add to the up-front cost.

3) A robo-advisor.
Wealthsimple has no minimum investment requirement and charges no annual advisory fee for accounts with less than $5,000 (though you're on the hook for the expense ratios of the underlying ETFs--which will vary depending on your asset allocation but should be in the 0.2% range). Accounts are automatically rebalanced when their asset weights stray too far from their targets, as determined by a proprietary algorithm, and whenever possible Wealthsimple uses dividends for the rebalancing so as not to trigger a taxable event.

+ Pluses: No advisory fees, automatic rebalancing, a solid lineup of low-cost market-cap-weighted and fundamentally weighted ETFs, and a slick smart phone app to boot. Also, the program's questionnaire allows you to specify your goals (retirement, a big purchase, and so on), time horizon and more.

Minuses: The selection of ETFs can seem somewhat limited to some investors. For instance, there is virtually no exposure to small-cap stocks.

Traditional benchmarks have a purpose, but they are impersonal and fail to reflect the messy realities of investing. Fortunately, today it is easier and cheaper than ever for investors to build their own benchmarks to better assess the value they are adding (or subtracting) to their portfolios--or the value that others might be adding (or subtracting) on their behalf. This exercise may reinforce your confidence in your own abilities to manage your portfolio or in the value of your relationship with a trusted financial advisor. On the other hand, it may lead you to realize that "benchmark" returns might actually be your best bet for meeting your goals and that your new personal bogey might deserve more of your investment dollars.

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About Author

Ben Johnson, CFA

Ben Johnson, CFA  Ben Johnson, CFA, is director of global ETF research for Morningstar and editor of Morningstar ETFInvestor, a monthly newsletter.

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