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.
Take the iShares North American Natural Resources (IGE) exchange-traded fund. Our firm recommends this in its Gone Fishing Portfolio, which are stocks that usually weather market gyrations. This iShares offering is based on the S&P North American Natural Resources Sector Index. The ETF’s return rests on how the index does, plus or minus the tracking error (how if differs from the underlying index’s performance), minus its expense ratio.
Some funds only approximate the holdings of the index, which may lead to tracking error. The index may have thousands of stocks and the fund only the largest few hundred. If the index’s large companies in do better than the smaller companies, the fund does better than the index. But if the smaller companies do better, then the index outperforms the fund. Additionally, the index may get add or delete stocks, and the fund’s managers take time to update its holdings. That largely accounts for tracking error.
Over the past 10 years (ending April 30), the IGE fund had an annualized return of 11.29 percent, while the index booked 11.83 percent. The reason for the 0.54 percentage point under-performance of the fund: its 0.48 percent expense ratio and 0.06 point tracking error.
What doesn’t make sense is comparing IGE to anything other than the index it follows. Even if you picked a different resource stock index, the comparison would not be fair. One would do better, but it isn’t either index’s fault that one happens to return more over a specific period.
EEM is based on the MSCI Emerging Markets Index, while VWO tracks the FTSE Emerging Markets Index. EEM has 849 stocks in it and VWO has 961. The indexes show different returns as well.
Last year, the MSCI index fell 2.60 percent, and the FTSE one dropped 4.28 percent. One year, one of these indexes bests the other and the next year the reverse may occur. Even two emerging market ETFs shouldn’t be compared to the same index.
This is why, in our latest quarterly report to clients, we included not only their portfolio’s return, but also the return of their portfolio in each of the six asset classes. Then we also ran the returns of over a dozen different indexes, such as the Dow Jones U.S. Select REIT and the MSCI Emerging Markets Small Cap.
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Written by David John Marotta, CFP, AIF, president of Marotta Wealth Management Inc. of Charlottesville, Va., providing fee-only financial planning and wealth management at www.emarotta.com and blogging at www.marottaonmoney.com. Both the author and the clients he manages often invest in the investments mentioned in these articles.
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