The standard that the investment world most typically uses for the performance of mutual funds and other assets is the Standard & Poor’s 500 index. That usually is a bad idea because the S&P, which contains the largest valued stocks in the U.S., seldom reflects the investments you own.
Craig L. Israelsen has a nice article in Financial Planning magazine entitled, “Best Benchmarks for Client Portfolios,” which explores the problem in depth of using this storied index as a benchmark. He notes how often investment management positions the S&P 500 as the performance comparison for a diversified portfolio containing stocks, bonds and such diversifying assets as real estate and commodities.
The chart below shows how seldom the S&P 500 is similar to a broadly diversified, multi-asset portfolio. Comparing such a portfolio against only one of its ingredients is not helpful, valid or even logical. It’s just loony.
Israelsen sets the problem up nicely, but his solution is to use the return of his own firm’s 7Twelve Index, calculated by S&P Custom index service return. Not everyone is willing to pay the S&P Custom Index Services to keep a static index. It’s better to be free to change your strategy.
Index investing makes a lot of sense, as opposed to investing in actively managed funds, which give a fund manager a lot of leeway and costs more (plus usually saddles you with higher taxes due to its increased trading). Index funds provide broad diversification across many stocks, often for a very low expense ratio – the fees you pay the fund.
But even after you have decided on index investing, there are over 8,000 different indexes to choose from. And that is the point. Using one index, like the S&P 500, to measure against the entire portfolio is foolish if your portfolio is comprised completely of index funds. You should compare each index fund to how well it tracks its own index.