Measure your returns with indexes

Investors use a wide range of indexes as benchmarks to help them measure the performance of the market and their performance as investors. For those who own stocks, they will refer to the S&P 500, Dow Jones Industrial Average (DJIA) and Nasdaq 100 to tell them “where is the market”. The value of these indexes is displayed daily in financial media around the world.

Most investors hope to meet or exceed the returns of these indexes over time. The problem with this expectation is that they immediately put themselves at a disadvantage because they did not compare Apple to Apple. Read on to learn how to use the index to provide an appropriate framework for your expectations and results as you strive to achieve your investment goals.

Key points

  • Most actively traded portfolios fail to exceed their benchmark indexes, especially after accounting for fees and taxes.
  • Therefore, most investors may find it wise to invest in passive index methods.
  • If you plan to adopt proactive management, you need to make sure to use appropriate benchmarks to compare your returns.

the data shows

According to the 2020 edition of the Standard & Poor’s “Index and Active (SPIVA) Fund Scorecard”, most actively managed funds-accounting for more than half of all mutual funds of this type-continue to underperform the S&P 500 Index.The report also shows that most individual investors who trade for their portfolios also lag behind the Standard & Poor’s. There are many reasons for a particular fund’s overperformance or underperformance in a given year, but there are several key reasons why most funds cannot outperform their indexes.

Investors always have to bear various so-called friction costs-transaction costs, load, commissions and capital gains taxes-all of which must be paid when they enter, exit, or move around a fund or portfolio. Investors even hold stocks in the form of management fees and account fees, even incurring friction costs.

However, the Standard & Poor’s Index has no friction costs. When used as a benchmark, it is a hypothetical stock included in a free investment portfolio with no transaction costs and no capital gains tax! In other words, when the S&P 500 and other indexes are used as benchmarks, they are different from the investment conditions in your portfolio, which makes it more difficult for you to beat them.

All of this now does not mean that the index is useless when viewing your own performance. Indexes are still extremely valuable tools used by investors to measure the overall health of large public markets. Each index tells us a story about the assets it contains. It eliminates the endless financial noise that would otherwise be generated day by day. However, the index usually cannot show the performance results of any type of real investment portfolio.

Although many investors have realized this to some extent, what is important is the understanding and application of principles—not just knowledge.

Benchmark error

The benchmark index is a measure of the performance of securities, investment strategies or investment managers. Therefore, it is very important to choose a benchmark with similar risk-return characteristics to the relevant securities, strategies or managers. Otherwise, the analysis may draw misleading and unreliable conclusions.

Today, investors have countless benchmarks to choose from. These include not only traditional stock and fixed income benchmarks, but also more exotic benchmarks created for hedge funds, derivatives, real estate, and other types of investments.

Choosing the right benchmark is important for investors and investment managers. Investors and managers pay close attention to their investment portfolios and their benchmarks to see if their portfolio performance meets their expectations. If the performance of the portfolio deviates significantly from the chosen benchmark, it may indicate a style drift. In other words, this may indicate that the investment portfolio has deviated from its ideal risk tolerance and investment style.

Benchmark error is a situation where the wrong benchmark is selected in the financial model, causing the model to produce inaccurate results.

Why benchmarks are important

The power of compound interest

Assuming you did use the appropriate benchmarks, what do you say this adds up to? When explaining the nature of investment performance, you may find this sentence useful: “The most powerful force in the universe is compound interest.” Who said this? A moderately successful thinker named Albert Einstein. Let’s temporarily consider two portfolios, each of which started investing with the same amount of funds on the same day 20 years ago:

  • Portfolio 1 (Rob: 11%)-initial value = 100,000 USD
  • Portfolio 2 (Alice: 12.5%)-initial value = 100,000 USD

End value (after 20 years):

  • Portfolio 1 (Rob’s): $806,231.15
  • Portfolio 2 (Alice’s): $1,054,509.38

Why is there such a big difference in the end value? Because Bob’s annualized rate of return is 11%, and Alice’s annualized rate of return is 12.5%. That’s it-a difference of 1.5% results in a cumulative difference of more than $200,000! If we consider the 1.5% return drag to be a conservative estimate of the friction costs that investors pay each year, we will quickly understand how important it is to understand these costs and keep them as low as possible.

Small steps

If you own a mutual fund, learn how to find accurate performance results in your literature, and pay attention to data deducting administrative fees and expenses. This will allow you to measure the performance of the fund more accurately. When researching mutual funds, always pay attention to the overall expense ratio-ratios above 2% are very expensive funds and have brought an uphill battle for investors from the start.

A useful investment exercise is to always expand your knowledge of what constitutes a good benchmark. The best benchmark represents your actual holdings in terms of investment style and cost. There are actually thousands of possible benchmarks, so regardless of the composition of your personal investment portfolio, you should be able to find one or two meaningful benchmarks to help you learn from the results and plan for the future effectively. Try to check some of them to expand your arsenal:

Lipper Indexes: These are very useful for mutual fund investors. Each style of Lipper Index represents the average of the 30 largest mutual funds in the category. So, for example, the Lipper Large Cap Index represents the 30 largest large mutual funds, the largest of which is determined by the asset size of the fund.

MSCI Indexes: These Morgan Stanley indexes are good benchmarks for international investors; they perform well in many international countries and regions. Considering the inherent difficulties of finding a good international benchmark, the MSCI set is a well-maintained and respected benchmark.

Industry SPDR (Spider): The results of these industry-themed ETFs are very useful for checking the performance of specific industries, whether for mutual fund holders or DIY investors.

Other important areas: In some cases, bond benchmarks or inflation can be used to make a huge impact. For example, many investors are happy to keep the principal they have earned while maintaining inflation. Not every investor is looking for volatility that increases as they seek higher returns.

Bottom line

Investors should always pay attention to proper asset allocation and diversification first when investing. However, no matter how we define benchmarks, benchmarks are a useful tool that can tell us how we perform compared to representative peers. By making some slight and careful adjustments to your expectations of performance returns, you can effectively compare relative returns and adjust your portfolio strategy as needed to provide you with the best chance of achieving your goals.

It is important not to rely too much on the performance data of the broad index. This is difficult because the index is widely regarded as the official measure of the stock market. Using an appropriate benchmark will keep you focused on your goals and costs incurred, and you can be a trusted ally on your path to investment success.


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