Build Your Own Benchmark

A version of this article was published in the September 2015 issue of Morningstar ETFInvestor. Download a complimentary copy of ETFInvestor here.

How do you track your progress toward your financial goals? How do you assess your abilities as the manager of your personal portfolio? How do you measure the value of a trusted advisor? Do you have a benchmark? If your answer is no, then you may want to consider building one.

Benchmarks play a central role in performance evaluation. They serve a “you are here”-type function that allows us to assess the state of the markets as well as the relative performance of the various “helpers” (to borrow a term from Warren Buffett) that we’ve hired to aid us in investing our precious capital with an eye toward meeting our financial goals.

On a stand-alone basis, any given financial index has limited utility. The S&P 500 can tell us a lot about how blue-chip U.S. equities are performing or how an actively managed large-cap stock fund is faring relative to the market at large, but it gives little insight into the performance of a globally diversified portfolio of stocks, bonds, and other asset classes, and less still into how this portfolio is progressing toward meeting one’s goals. In isolation, an index is inherently impersonal and sterile.

Of course, it is simple enough to combine multiple indexes, each representing distinct asset classes, in a mix that mimics an asset allocation aligned with an investor’s goals and willingness and ability to assume risk. Such a blended benchmark is inherently more representative of an investor’s true experience than a single asset-class yardstick in a vacuum. However, even a custom solution like this still falls short.

A blended benchmark fails to account for the messy reality of investing--most notably, costs. Indexes do not adequately capture the effects of fees, investors’ specific tax circumstances, or the cost of advice.

Low-cost index mutual funds and exchange-traded funds covering an ever-expanding array of broad asset classes and niche strategies have proliferated over the past two decades. This trend has coincided with widespread technology-driven deflation that has driven down trading costs and is increasingly pressuring the cost of advice by automating asset allocation and fund selection. These trends have made it possible for investors to build and invest in their own custom “benchmark” in a matter of minutes. I think that there is a massive amount of value that can be realized by allocating a token amount of one’s financial capital to such a portfolio.

A real-money bespoke “benchmark” is as useful a guidepost as anyone can likely build. Investors can employ such a portfolio to assess their own investment decisions, the value of the decisions that other “helpers” (portfolio managers, advisors, and so on) are making on their behalf, and their progress toward their financial goals. I believe that this sort of construct has more merit than a blended “paper” benchmark in that it 1) will inherently reflect all the various costs listed above and 2) is seeded with real money. Having a real-money portfolio as a benchmark, no matter how small the amount, has the benefit of making the opportunity costs (essentially, the performance of your benchmarked portfolio minus the performance of the “benchmark”) more fungible.

The Makings of a Good Benchmark What makes a good benchmark? In "Managing Investment Portfolios: A Dynamic Process," [1] a good benchmark is described as follows:

In practice, an acceptable benchmark is one that both the investment manager and the plan sponsor agree represents the manager’s investment process. However, in order to function effectively in performance evaluation, a benchmark should possess certain basic properties. It should be:

Unambiguous. The names of securities and their corresponding weights in the benchmark should be clearly noted.

Investable. The benchmark should be available as a passive option.

Measurable. It should be possible to calculate the benchmark’s return on a timely basis, for various time periods (e.g., monthly, quarterly, annually).

Appropriate. The benchmark should be consistent with the manager’s investment style or area of expertise.

Reflective of current investment opinions. The manager should have opinions and investment knowledge of the individual securities within the benchmark.

Specified in advance. The benchmark should be specified prior to the beginning of an evaluation period and known to both the investment manager and the fund sponsor.

Owned. The investment manager should be aware of and accept accountability for the constituents and performance of the benchmark.

A portfolio of low-cost index funds and/or ETFs designed to fit an investor’s specific goals and circumstances ticks all of these boxes. Furthermore, it is fully investable, can be quite literally owned, and as such will reflect all the associated costs of initial investment and ongoing ownership. Now that I’ve hopefully convinced you that this isn’t a completely cockamamie idea, I’d like to cover some specific means by which you can actually build your own benchmark.

Today It Is Easier and Cheaper Than Ever to BYOB Technological advances have made it easier and cheaper for investors to build their own benchmark. There are a variety of different ways to do it. Here I share three of the lowest-minimum-investment, lowest-cost, lowest-maintenance options available.

1) An age/target retirement-date-appropriate index-based target-date fund. Vanguard's target-retirement funds have a $1,000 minimum investment, charge an annual fee of 0.16%, invest in broad-based Vanguard index funds, and their asset allocations are actively managed and regularly rebalanced by the funds' managers. The firm's target-date lineup is one of just two target-date series to receive a Morningstar Analyst Rating of Gold.

+ Pluses: This is the lowest-minimum-investment, lowest-cost, lowest-maintenance option for a personal benchmark I can imagine.

– Minuses: A target-date fund is most appropriate for benchmarking one's progress toward retirement-related goals. It isn't as useful for purposes of benchmarking one's progress toward other major financial milestones.

2)

A two-ETF portfolio.

Investors can get broad, uber-low-cost exposure to global equities and investment-grade U.S. bonds by combining

VT (0.17% expense ratio) and

BND (0.07% expense ratio). The appropriate mix would, of course, depend on an individual’s specific circumstances. At present, a 70/30 stock/bond mix would currently consist of approximately four shares of VT and roughly one share of BND, for a total price of about $290 and an asset-weighted fee of around 0.14%. These ETFs trade commission-free on Vanguard’s brokerage platform, where the account minimum is $3,000.

+ Pluses: This approach is nearly as simple and inexpensive as it gets.

– Minuses: There is a minor amount of up-front homework and ongoing maintenance required in this approach with regards to determining and subsequently rebalancing to one's target allocation. Some might consider it to be overly simplistic or inadequately diversified.

3) A "robo" advisor. The Charles Schwab Intelligent Portfolios program has a $5,000 minimum investment requirement and charges no annual advisory fee (though you're on the hook for the expense ratios of the underlying ETFs--which will vary depending on your asset allocation--and Schwab is also collecting a rent on cash balances). There is an automatic rebalancing feature for accounts with balances of more than $5,000, and there is an automatic tax-loss harvesting service offered for accounts with balances greater than $50,000.

+ Pluses: No advisory fees, automatic rebalancing, a solid lineup of low-cost market-cap-weighted and fundamentally weighted ETFs, and a slick iPhone app to boot. Also, the program's questionnaire allows you to specify your goals (retirement, a big purchase, and so on), time horizon, and more.

– Minuses: The portfolio will not be fully invested--there will be a cash allocation (this has proved controversial given that Schwab will be making money off these cash positions). Also, this option has the highest minimum investment of the three.

Traditional benchmarks have a purpose, but they are impersonal and fail to reflect the messy realities of investing. Fortunately, today it is easier and cheaper than ever for investors to build their own benchmarks to better assess the value they are adding (or subtracting) to their portfolios--or the value that others might be adding (or subtracting) on their behalf. This exercise may reinforce your confidence in your own abilities to manage your portfolio or in the value of your relationship with a trusted financial advisor. On the other hand, it may lead you to realize that “benchmark” returns might actually be your best bet for meeting your goals and that your new personal bogy might deserve more of your investment dollars.

[1] Maginn, J. Tuttle, D., McLeavey, D., et al. 2007. Managing Investment Portfolios: A Dynamic Process, 3rd ed. (Hoboken, NJ: John Wiley & Sons).

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