Many investors describe their portfolio performance in raw returns, like, “my portfolio made 15% last year” or “my portfolio gained $300,000”. While such statements may be true, they don’t tell us the whole story. And cannot tell us whether results have been good or bad. Since, what if the average return was 20% compared to our own 15%? We may have received $400,000 instead of $300,000. Or what about the same results with half the risk? To determine whether our returns are truly good or bad, we need to compare our returns vs alternatives.
This is where benchmarking comes in. Portfolio benchmarks can help evaluate returns and put our returns (and risk) into context.
This post will help readers understand what investing benchmarks are, what active returns tell us about performance, and how to evaluate our investing results.
What is Benchmarking?
Benchmarking refers to comparing a portfolio’s returns against a relevant alternative, like an index. Common indexes are those like the S&P 500, which tracks the US stock market. By comparing returns to a relevant benchmark, it becomes possible to know whether a portfolio is performing well or just riding the tide of broader markets. Benchmarking also helps us evaluate our investment advisors to determine if value for fees is being received. In addition, benchmarks help measure risk-adjusted performance, which ensures that volatility is taken into consideration.
What is Active Management?
Active management is the attempt to outperform benchmarks by selecting investments or adjusting asset allocation to achieve superior results. The alternative to investment advice is called passive management, which uses low-cost index funds that track portfolio benchmarks instead.
One of the best ways to evaluate investment advice is to compare a portfolio’s own returns against their passive benchmarks. In other words, what would the portfolio have returned if we didn’t pay a fee for investment advice, and instead, just invested in the passive benchmarks? This brings us to the concept of “active return”.
What is an Active Return?
Active return is the difference between what your portfolio returns vs the passive benchmark return. For example, if your US stocks returned 5%, and a benchmark (like the S&P 500 Index) returned only 4%, then you have generated 1% of “active return”.
An entire portfolio’s active return evaluates the mix of all the different investments held such as stocks, bonds, and real estate (the amount held in each asset class). And also, the individual investment selection (the specific stocks or bonds chosen).
Reporting Active Returns
We generate performance reports that show not just raw returns but also active returns using benchmarks. We measure volatility and use metrics like the Sharpe ratio (which looks at return per unit of risk) to determine whether a return was actually worth paying for.
Reading Our Reports
When you read the reports our family office generates. Pay attention to the difference between your benchmark asset allocation vs the portfolio’s actual asset allocation. And also notice the “active returns” which are the difference between what the portfolio returned vs the benchmarks. This will tell us whether the returns achieved are indeed good or bad. Take a look at report number two here as an example.
Making Decisions
Once we know how our portfolio is doing relative to benchmarks, we should also consider “why”. Are we underweight or overweight some asset classes? Is security selection making an impact? What are the reasons why we’re doing good or bad? Once we can determine the reasons behind our results, we can take steps to improve them.
