Do You Need a Real-Money Benchmark?

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Many investors may have heard they need a benchmark, but they may struggle with the logistics. Joining me to discuss this topic is Ben Johnson. He is editor of Morningstar ETFInvestor.

Ben, thank you so much for being here.

Ben Johnson: Thanks for having me, Christine.

Benz: Ben, you wrote a piece in the September issue of ETFInvestor, where you talked about benchmarking, why you need a benchmark, and also you put forth a few simple ideas for benchmarking your portfolio. But let's start with why someone needs a benchmark. Why is that an essential ingredient in any sort of portfolio plan?

Johnson: Well, I think there can be a lot of value to be found in building one's own benchmark--a benchmark that reflects your personal circumstances, reflects your asset allocation, reflects your fund-selection decisions, and reflects also some element of the cost of advice or the cost of help in one form or another. I think by placing a de minimis amount of money in such a benchmark, which is easier to do today than ever before--and we can get deeper into that in a minute--it gives you a useful touch point in terms of how you are doing. Are your decisions adding value or are they subtracting value? And by investing real money into your own bespoke personal benchmark, you have a real fungible sense of what that opportunity cost might be, what money you might be leaving on the table by opting for your current course or your current plan, or you might learn that you're doing really quite well--in terms of picking funds, in terms of selecting your appropriate asset allocation, in terms of selecting a helper to help you do all of the above.

Benz: You mentioned a real-money benchmark; that's a little different from what I've recommended to Morningstar.com users with our portfolio manager, where they could set up a mirror portfolio. You suggest that they actually take dollars, put it into this portfolio, and use it as a benchmark.

Johnson: I say that because I think it's really quite simple to easily dismiss something that you might see in paper format--something that you might have built using some of the multitude of tools that we make available to investors via our website. I think if you put actual skin in that benchmark--and it doesn't have to be much, just a token dollar amount into one of these benchmarks--it becomes real. It brings that benchmark to life, and it really frames that potential opportunity cost in real-dollar terms. So, I think there is sort of an important behavioral/mental mechanism or a switch that gets flipped by virtue of putting real money in your own personal benchmark.

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Benz: In the article, you laid out some criteria that you think good benchmarks should have. Let's talk about some of those. If I'm creating a benchmark, what characteristics should I make sure that it has?

Johnson: I think the one characteristic that I'd add to my prior comment that a real-money benchmark has is that it reflects all of the messy reality of investing real dollars into real funds in a real asset-allocation strategy--the messy realities chiefly being things like costs and taxes. So, that's vitally important.

The other thing to keep in mind is that it reflects your reality. Everyone can benchmark themselves against the S&P 500, but the S&P 500 means nothing in terms of my personal circumstances. What is my specific goal? Is it saving for retirement? Is it spending through retirement? Is it saving for a significant purchase--say, university tuition? None of that is recognized by a bog-standard benchmark nor necessarily a blended benchmark of, say, the S&P 500 and the Barclays U.S. Aggregate Bond Index.

So, by selecting and building your own benchmark, it reflects your personal circumstances, your personal goals, and--again, if you do it in a real-money form--all of that messy reality of investing.

Benz: So, you invest in products that have costs attached to them instead of indexes. In the article, you laid out some ideas for what you think are reasonable real-money benchmarks. The first is, I think, a pretty intuitive way to think about benchmarking a portfolio; it's to buy a target-date fund--a good one, presumably--and see how you do relative to that.

Johnson: I think there is no more low-cost, low-maintenance, hassle-free personal benchmark you could use than, say, a Vanguard target-date fund--one that's age-appropriate. Vanguard's target-date lineup is investable at a fee of 18 basis points. It's one of just two target-date series that receive a Morningstar Analyst Rating of Gold. So, this is a very simple, low-cost way to create your own real-money benchmark.

Now, the only drawback is that these are designed with retirement savings in mind. So, they might not necessarily fit your unique circumstances if you're looking to use this as a benchmark for [assets you're saving up for something other than retirement].

Benz: Or if your human capital is much different from what's implied in that target-date glide path, you may want to have a different asset allocation.

Johnson: That's absolutely the case. There's the classic example of a tenured university professor, who has very bondlike human capital and should have a lot of willingness to load up on, say, equity risk because so much of my total capital looks like a bond. That's, I think, an important point and one that a lot of these benchmarks might miss, especially when you think of some of the questionnaires that build portfolios and typical asset-allocation models or robo-advisors. They're going to miss those things that a living, breathing human helper, an advisor, would pick up on--knowing you and knowing your personal circumstances outside the context of ticking boxes and filling standard forms.

Benz: Another idea for benchmarking is using a very basic basket of index ETFs or traditional index funds. Let's talk about what that might help you do if you invested in that ETF basket that, say, mirrored your own asset allocation in your portfolio of more complicated ingredients.

Johnson: Again, it's just a touch point, and it's one of a multitude of options; but you can build a two-ETF portfolio, say, using Vanguard Total World Stock ETF (VT) and Vanguard Total Bond Market ETF (BND) in an appropriate mix that reflects your risk tolerance and your circumstances at a very low cost. That serves to give you a basis of comparison for your fund-selection decisions that you might make otherwise and asset-allocation decisions that you might make otherwise. It also helps you to frame the cost of advice that you might be laying over investments that you might have elsewhere. So, again, it's meant to be a touch point--a way of measuring the decisions that you might already be making or considering making with your investment capital elsewhere.

Benz: The last idea that you put forth as a benchmarking idea is to use some sort of a robo-advisor. Before we talk about the pros and cons of using that as a benchmark, let's talk about what a robo-advisor is. They are all a little bit different, but let's talk about the commonalities and so on.

Johnson: So, they're all a little bit different; but in broad brushstrokes, a robo-advisor is an automated asset-allocation and fund-selection framework. You get on to your computer, you log on to a website, you enter a bit of information about yourself, and this tool will spit out an asset allocation that reflects the information that you provided via a questionnaire. It will select from amongst a group of preselected funds--typically exchange-traded funds, ETF's--and then it will invest your capital.

So, within a matter of five minutes, you can have a fully diversified, low-cost, customized-asset-allocation portfolio via one of these technologies. It's really just a technology solution. It's a process that has existed elsewhere. It has existed in traditional advice channels. It has existed in 401(k) channels for years. It's just been branded with a fancy new name that has caught a lot of people's attention.

Benz: So, I plug in my information, and I get my robo-advice. In terms of how I would take that and use it as a benchmark, let's talk about how that would work.

Johnson: Well, some of the more advanced models today allow you to do a bit more customization in terms of what your time horizon is and what your specific goal is. They're not necessarily set up specifically to generate asset allocations that are looking at a retirement goal that is 30 years out. You can bring it up to a five-year large-purchase type of goal--university savings or buying a boat, for instance.

So, there's more customization there, and I think over time what you'll see as these models continue to evolve is that there will be more bells and whistles. Automated tax-loss harvesting is one feature that some robo-advisors offer today. So, they're automating some of these other value-added services that typically might have been handled by a living, breathing human advisor.

Benz: Ben, this is an interesting topic and an important one for investors. Thank you so much for being here to share your insights.

Johnson: Thanks for having me.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.