Benchmarking: A Compass for Evaluating Investment Performance

As Financial Advisors, one of our top priorities when meeting with a new client is to gain a complete understanding of their risk profile so that we can appropriately construct a portfolio suited for them. 

Several factors go into determining how conservative or aggressive a client should be with their investments: History of investing, upcoming life events, future income earning potential, retirement plans, and future needs from the investment account are only some to consider. 

When the stock market performs well, clients tend to overestimate their risk tolerance. So just asking how well they can handle volatility typically results in a portfolio that’s misaligned with their actual ability to handle risk and can prevent them meeting their goals. 

Once we agree on an appropriate portfolio allocation, the next challenge is determining an appropriate measure to compare the performance of a client’s specific portfolio. This process is known as benchmarking. 

What is Benchmarking? 

In the context of investment accounts, benchmarking is the practice of comparing the performance of a particular investment portfolio or strategy to a predefined standard. These benchmarks are typically market indices or a specific group of securities representing the asset classes or sectors in which the investment is made.

Common examples of benchmarks include the S&P 500 for U.S. stocks, the MSCI World Index for global equities, and the Bloomberg U.S. Aggregate Bond Index for fixed-income investments. 

Benchmarking is an essential tool for assessing the relative success of an investment strategy.  By comparing the returns of an investment account to an appropriate benchmark, investors and financial advisors can determine whether their investment decisions have outperformed or underperformed. 

Investment Benchmarking Examples

Let’s illustrate the importance of benchmarking in assessing the performance of a portfolio with a few straightforward examples. 

Example 1: 

Let’s assume that Client A has been with his financial advisor since January 1, 2021 and they agreed to have an investment portfolio equivalent to a 60% allocation to U.S. equities and 40% to U.S. fixed income. Since that time and through September 30, 2023, Client A’s portfolio is up 5.2% over that timeframe, net of fees.  So, how did the financial advisor do? 

Over that timeframe, the S&P 500 Total Return (SPXTR) was up 19.17% and the Core US Aggregate Bond ETF (AGG) was down 20.43% (including interest paid). The benchmark for Client A’s portfolio would be 60% of the S&P 500 and 40% of the Core U.S. Aggregate Bond ETF. When combined, the benchmark had a total return of 3.33% 

While the Client A’s account was only slightly up during that time frame, the portfolio actually outperformed it’s benchmark. 

Example 2: 

Client B hired her financial advisor on January 1, 2019 and they agreed to have a more aggressive portfolio, with the equivalent of 80% invested in U.S. based equities and 20% in U.S. fixed income. Since inception through September 20, 2023, Client B’s account was up 42.3%. How did Client B’s portfolio do? 

During that period, the S&P 500 Total Return (SPXTR) was up 85.52%, while the Core U.S. Aggregate Bond ETF was down 11.69%. The blended benchmark for this portfolio was up 66.08%.  

In this example, Client B’s portfolio had a very nice absolute return, but Client B’s financial advisor severely underperformed the benchmark. 

Summary

Benchmarking is an invaluable tool for assessing the performance of an investment account. Investors and financial advisors can draw informed conclusions about their investment strategies by comparing returns and risk to a suitable benchmark. Absolute returns can be very misleading. A high absolute return does not necessarily mean an investment strategy is working. Conversely, a low absolute return does not mean a particular strategy is underperforming. 

If this discussion about benchmarking has sparked questions or if you wish to learn more about how these concepts apply to your own investment journey, please feel free to reach out to the team at Tripletail Wealth. We’re ready and eager to assist you in navigating your financial path towards success.