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Do your investments measure up? How to assess them

Benchmarks help investors gauge their portfolio's performance, but these measuring sticks can be as misleading as they are helpful

By: JOEL SCHLESINGER

Date: October 13, 2017

On the surface, a benchmark is a simple investment concept to wrap your head around. You're comparing the performance of your portfolio to that of another similar basket of investments.

Yet dig a little deeper and the process is more complex than it first appears.

"It can be very complicated," says Alan Fustey, a portfolio manager with Index Wealth Management in Winnipeg, which specializes in low-cost, exchange-traded fund (ETF) strategies.

That's in part because a good benchmark must be so many things. "A good benchmark must have five attributes: It must be investable, accessible, transparent, independent and relevant," Mr. Fustey says.

If a benchmark doesn't meet these criteria, investors are not going to get a good snapshot of their portfolio's performance, he says.

And yet many of the so-called benchmarks that investors see today in financial materials often paint a partial and somewhat misleading picture of performance.

Mr. Fustey points to the oft-used benchmark of one's peer group, which measures the performance of all similar investments.

For instance, an investor can compare a Canadian equity mutual fund to the collective performance of all Canadian equity mutual funds. The comparison seems reasonable, but it's "not really a good benchmark because it fails on the fact that it's not investible,"" he says. "You can't own all those mutual funds in one investment."

Investors instead should seek a benchmark that is relevant to what they own and their goals for their money, says David Rowen, managing director at Phocion Investment Services in Montreal.

The first step is to understand what you own in your portfolio. "Very few investors roll up their sleeves and look under the hood," says Mr. Rowen, who specializes in assessing for institutional clients the performance of their investment portfolios.

All too often, investors rely only on benchmarks that can be deceptive, particularly those offered by investment firms that are managing, or seeking to manage, their money.

Mr. Rowen points to one case: a client investing with a hedge manager who claimed the portfolio outperformed the benchmark by more than 40 per cent. But the comparison was not accurate because the manager's performance included the total return — price growth and dividends — while the index reflected only price growth.

In reality the growth of the portfolio was much less, he says. "All that stuff confuses investors and helps them make not the best decisions."

That doesn't mean all benchmarks that are presented to investors are inaccurate. Investors should "create a list of strengths and weaknesses" for the benchmark they're using, he says, then decide whether the weaknesses outweigh the strengths.

Investors can do their own benchmarking so long as their portfolio is fairly straightforward. For example, if your portfolio consists of only large-cap Canadian stocks, then you could compare its performance to that of the TSX 60, which tracks the largest publicly traded companies in Canada, says Gail Bebee, author of No Hype: The Straight Goods on Investing Your Money.

"I personally take the benchmark data and plug it into an Excel spreadsheet that has my overall target asset mix in it," she says.

So if 50 per cent of the portfolio is invested in Canadian fixed income, she might compare that portion to the FTSE TMX Canada Universe Bond Index. And if 25 per cent of the portfolio is invested in U.S. stocks, she could compare it to the performance of the S&P 500.

Yet this method also has limitations. "Using the TSX 60 for your Canadian equity portfolio is only relevant if all your assets are invested in large-cap Canadian stocks," Mr. Fustey says, adding that the picture becomes cloudier if you own small-cap stocks, too. You would need to measure that portion against a passive ETF that follows Canada's small-cap stock universe, he says.

While this process can be illuminating, its limitation is that it tells investors only whether they are outperforming the benchmark or underperforming it. It says nothing about risk — a key piece of good portfolio management.

Mr. Rowen says addressing risk is perhaps the most important benchmarking piece of all, especially for high-net-worth investors, do-it-yourselfers and others who may be using active strategies.

A number of metrics do just that, he says. The most common is the Sharpe Ratio, an industry standard that is used to examine the performance of an investment while taking into account the standard deviation, or volatility, of the portfolio.

"It's extraordinarily easy arithmetic," Mr. Rowen says.

While it is elementary to an investment professional, the math may seem mind-bending to the average investor. A few financial blogs and other investment sites provide ways to calculate the ratio on your own.

With that in mind, a good way to learn how a portfolio measures up is to ask how it is performing relative to the investor's goals, Mr. Rowen says.

"The investor always has to think about performance on the basis of 'what's my objective, what am I trying to achieve?'"

If a portfolio has averaged 6 per cent annual returns, for example, and the investor requires 4 per cent returns to reach her goal, then she has a good indication that her investment strategy — at least for the time being — serves its purpose.

If it seems a little oversimplified, that is the point, Mr. Rowen says. He recommends investors make their portfolios as uncomplicated as possible because a straightforward strategy's performance is much easier to measure.

It is advice that more high-net-worth investors — who often invest in complex hedge funds — should take to heart, he says.

"High-net-worth investors get mesmerized by all the fancy words and elaborate descriptions, but the more complex it is, the harder it is to measure against something else," he says.

"The simpler things are the better."

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