September 16, 2013
A Few Thoughts On Why Benchmarking Is Essential
Last week’s news that the Dow Jones Industrials Average was changing its lineup of stocks inspired some pundits to advise that keeping an eye on indexes generally for purposes of benchmarking your investment strategy isn’t worth your time. This recommendation arises from the fact that the Dow Jones Industrials and its counterparts aren’t really passive benchmarks and so any comparisons of your portfolio with these yardsticks is misguided. In fact, there are several problems with this line of thinking, and it’s worth our time to consider why.
First, let’s get one thing out of the way: dismissing benchmarking by way of the Dow Jones Industrials is a straw man. As equity indexes go, the original stock market benchmark is a poor choice for a number of reasons. As I noted a number of years ago, the nostalgic curiosity surrounding this index doesn’t change the fact that it’s “bottled in a methodological formaldehyde” by way of price weighting, which requires statistical contortions to maintain it through time. Even worse, it’s a small and unstable sample of the US equity stock market and so it’s best to view the Dow Jones Industrials as a fossil.
The good news is that there are a number of superior alternatives, such as the Russell 3000, if we’re trying to measure “the market”. But the real issue with benchmarking is much broader, namely, developing a model portfolio that serves as a robust measure of the opportunity set that’s appropriate for you (or your institution). Some pundits tell us that this approach is foolish, and that we’d be better off investing based on our investment objectives, risk tolerance, specific time horizon, and other factors. In short, forget about indexes and focus on investing by way of what’s important to you. Agreed, except for one point: In order to achieve those and related goals, benchmarking is an integral part of the solution.
There are many reasons for why this is so and I’m not going to go off the deep end here. But a few quick points illustrate why most of us can’t afford to ignore benchmarking. First, once you recognize that a reasonable investment strategy for most investors draws on multiple asset classes, it follows that you need some context for deciding how to define the playing field in order to recognize what you can earn easily, at low cost, and without the demands of investing or forecasting skills. Why do we need this benchmarking perspective?
To answer that, let’s imagine the opposite extreme: we’re clueless about the risk and return profile of a representative multi-asset class portfolio. As a result, we’re not sure about how it’s structured or what it’s earned. That means that we’re making choices about how to build our asset allocation strategy in a vacuum. To be blunt, we’re flying blind. Yes, if you’re a genius in financial analytics, along the lines of a Warren Buffett, you can do your own thing and succeed quite nicely without benchmarking. But exceptions to the rules aren’t likely to dominate for most of the crowd. Indeed, as one facet of benchmarking multi-asset classes portfolios reveals, running far afield of Mr. Market’s asset allocation can be treacherous, even among the well-informed world of informed money managers. The idea that intentionally ignoring global markets—a formalized ignorance, if you will—is likely to produce better results is akin to hoping that we’ll do just fine in earning a paycheck by assuming that we’ll find a bag of money on the sidewalk tomorrow.
In fact, studying the benchmark—Mr. Market’s portfolio—yields lots of valuable insights for designing and managing your own portfolio. For instance, we know that a passive, market-value weighted mix of all the major asset classes tends to be competitive through time. As a result, we should dissect this benchmark in order to understand what’s driving it—i.e., how its component indexes are weighted. That gives us some idea of how we might change Mr. Market’s asset allocation to adjust the portfolio to match our own specific risk and return objectives.
Why look at investing from this standpoint? Because there are decades of research showing us that trying to beat a reasonable benchmark within a given asset classes is difficult—particularly after adjusting for taxes, trading costs and other market frictions. What’s true for stocks and bonds, REITs and commodities, tends to be true for multi-asset class portfolios. With that information in hand, there’s a compelling case for understanding what you can earn easily, with minimal effort and cost. Successful investing strategies start with knowing your competition—the market. As such, we need a robust benchmark of this competition.
It’s a false argument to say that indexes are “managed” because individual components are bought and sold periodically. Ignore this digression. Instead, recognize that the real-world proxies for indexes—ETFs and index mutual funds—represent what’s available to anyone and everyone. Taking that point one step further, an ETF-based measure of Mr. Market’s asset allocation—see my ETF-based Global Markets Index Fund (GMI-F) benchmark here, for instance—represents a real-world opportunity set. You can also look to a select number of investment products as asset allocation benchmarks too, as I discussed here. Ideally, you’ll build your own benchmark, customizing a strategy that’s right for you.
What you shouldn’t do is assume that you can ignore markets in the quest to manage the associated risk. The ancient wisdom of Sun Tzu applies here: know your enemy. Mr. Market isn’t our enemy, but he’s the elephant in the room when it comes to competing strategies, and given his history of delivering reasonable, and even stellar results at times, it’s a no-brainer that we should keep an eye on his actions. Ignorance, after all, rarely has a big payoff in the world of finance.
Posted by jp at September 16, 2013 6:12 AM