Tracking Investment Portfolio Performance

Investment Perspective – October 2019

“Neither the investing method nor the fundamentals of the business are right or wrong because the mood of the market is favourable or unfavourable toward the “stock”. That is because when you really think about it, “stocks” (shares) are all about the financials and the trading price, the share price… the cash up value. What matters more is the economics of the business” 

Peter Flannery

Benchmarks, share market indexes and investing

Benchmarks for investing are generally a good idea.  That way, we have a reference point for comparison.  There are some limitations though.

Commonly, share market indexes (e.g. The Morgan Stanley Capital Index – MSCI, The US share market – Dow Jones / S&P 500, The Australian share market – ASX, The New Zealand share market – NZX) are used for comparison purposes.  They tend to be more reliable for comparison purposes longer term – 10 years plus.

Perhaps the best benchmarks are the investors specific requirements and goals, because broad share market indexes bear minimal relevance to investor specific goals.  To be clear, investment portfolios are better linked to the achievement of personal objectives.  The best place to start is ‘Investment Purpose’ and then ‘Investing Strategy’ because they are directly linked to, not only the investment portfolio but also to the investor – broad share market indexes are not.   

There are a couple of considerations to take into account when using share market indexes as benchmarks. 

1. Short term comparisons offer little value.

That is because markets are driven by sentiment and therefore larger variations from one year to the next are more a reflection of market sentiment than the calibre of the underlying investments. Swings in market sentiment can favour either the broad index over the investors more narrow portfolio and vis versa.  That movement and the resulting comparison showing either the index or the investors portfolio rising faster may not indicate superior quality investments or be an indication of future results;

2. It can be a challenge to locate an index that closely matches an investor’s portfolio.

For example, at WISEplanning, we are value investors, so we are investing in the underlying business rather than the movement in the trading price or playing the share market. Price and value are different but can move closer together long term.  Benchmarks measuring share market indexes can be useful over the long term (10 years plus).  Even with shorter timeframes, benchmarks can offer a guide as to how the cash up value of the portfolio is growing compared to a particular index / benchmark but can be less accurate. 

In the short term, indexes used as benchmarks measure market sentiment (share prices rising and falling), which is of some use if the investment methodology applied to the investment portfolio is based around modern portfolio theory (managed funds), momentum investing (share brokers) or other methodologies that play the market.  Whilst it is still useful for value investors long term, in the short run, market indexes that match a value investor’s portfolio are difficult to locate.  Still, long term, they provide a reference for comparison, but it is questionable as to how accurate the comparison actually is (e.g. comparing several hundred shares that make up an index with say 25 businesses in an investment portfolio is not a like for like comparison);

3. Investing in businesses is a different methodology to investing in shares.

That is because the financial analysis used by share brokers, fund managers and advisers, who practise modern portfolio theory and momentum investing, is a separate and different approach to the way value investors invest. Value Investors also take into account the economics of the business. 

Share market indexes are based on market capitalisation and trading prices, whereas investments for value investors are based on the financials and the economics of the business. This comes together to establish the intrinsic value of a business – different thing to the trading price.  Long term though, the price and the underlying value can move closer together, which means that this type of benchmarking (using share market indexes) can still be useful in the long run (10 years plus) but not always accurate in the short term;

4. A share market index will not hold cash, whereas an investment portfolio will.

Longer term, actually, this will matter less because after all, we are looking for the cash up value of the portfolio to grow and expand regardless of cash levels. In the short term though (e.g. less than 10 years) holdings of cash will either be a drag on performance when markets rise steadily and / or strongly or can add to performance when markets are volatile (and value investors have the opportunity to average down);

5. Which index do we use as a benchmark?

At WISEplanning, the Morgan Stanley capital index (MSCI) is the most likely option because it covers global markets, which is not a match for how we invest but is a less worse match than other options. For example, using the Dow Jones or the S&P500 indexes only measure the American share market and each index measures it differently.  When we look closely, the make-up of each index would bear little resemblance to portfolios designed and managed at WISEplanning. 

Using the Australian index would be a poor match because of the limited exposure that our clients have to the Australian market; however, it is an index (the ASX) that is close to New Zealand.  Using the New Zealand index (the NZSE) is a poor match because our clients also invest outside of New Zealand.  Often, people look at term deposit rates and use that as a comparison because that is another way that they would likely invest anyway.  Again, a poor comparison because fixed interest is a totally different asset to direct shares; and

6. Share market indexes do not have fees levied against them.

WISEplanning and other advisers, fund managers and share brokers, all charge fees and / or brokerages one way or another. Indexes do not have costs levied against them, so could be considered to have an advantage that way.  This leads those taking a more academic approach to investing to consider that a collection of exchange traded funds or index funds that have no management fees attached might be a good way to invest.

It is well known that index-based funds such as exchange traded funds (ETF’s) usually outperform actively managed funds long term – not always but mostly.  There are two main reasons.  First reason: the higher level of fees charged by managed funds compared to the lower administration fees of index funds.  Second reason: modern portfolio theory as an investing methodology is designed (possibly unwittingly) to dampen volatility and more or less match the market.  The problem is the combination of an investing method (asset allocation) that by default usually matches the market, investing errors by fund managers and the higher level of fees.       

Still, whilst index fund investing works OK for less advanced investors when markets rise and is generally considered low cost, when markets become volatile and uncertain, there is limited opportunity to take advantage of the volatility.   Therefore, returns over the long run, are stifled.  The damage to the compounding advantage can be significant in terms of money never made. 

7. Investing in index-based investments builds in a performance limitation or ceiling on investment returns.

When we invest in the index, we become the market so outperforming that market becomes virtually impossible. Diversification becomes ‘di-worsification’ (compromised ROI) as Warren Buffet once said many years ago.

Also, the money that chased those effortless gains during the rising ‘bull market’ can quickly bail out when volatility strikes – causing the funds to decline sharply and along with it the cash up value of the portfolio. 

Share market indexes reflect market sentiment across the market and therefore market pricing.  Not the same thing as the intrinsic value of a business. 

So, benchmarking using share market indexes and term deposit / bond returns can provide a useful reference point for investors generally, particularly in the long run (10 years plus). 

In the short term, these benchmarks are less reliable. 

One of the ongoing challenges for value investors is to locate an index that can be used as a benchmark that accurately reflects the aggregate of those businesses that make up the investor’s portfolio. 

Investor specific goals are likely the best benchmark for an investment portfolio long term because they are relevant to the investor.  Broad share market indexes – not so much.

“In the investing world, the rear window is much clearer than the front windscreen”

                                                                                                                      Warren Buffett