Lessons Learned
Don’t you hate to see the S&P 500 zoom up in price while your investment holdings sit there watching the parade go by? You say to yourself, “I should have put all my investments into this index”. Human nature has a natural tendency to look backwards and contemplate what we could have done better. Reflect on the fact that no decision will have a perfect outcome and that index envy will not assist in portfolio management. There is a better method for attaining your desired investment goals.
" I wished I had held the S&P 500 for the last ten years" (total return of 258.5% versus the S&P TSX 60 returning 140.39%)
"On second thought, the S&P TSX 60 is a better holding" (short term bias, TSX 60 returning 12.81% for the one year ending April 26, 2022, versus the S&P 500 realizing a meagre 0.95% total return)
Why are we fixated on connecting our personal return goals with an arbitrary benchmark? I could be a Canadian investor that establishes a portfolio with a 50/50 split between equities and fixed income. I select a benchmark(s) to judge my relative performance. I could select the Canadian, U.S., or international indexes or some combination. Then at the end of each year, I can monitor what I have achieved relative to this subjective benchmark. This is problematic as a benchmark should be fixed at the onset of the comparison period. I cannot change the benchmark from year to year to reflect my current desired asset allocation. Doing this can leave the investor comparing their returns against an ever-changing, subjective index selection.
When does benchmarking make sense? Most often for an institutional investor with multiple sub-manager investment mandates. An institution decides to hire an external equity manager to invest in large-capitalization U.S. stocks. The S&P 500 index would be an excellent benchmark to periodically compare the manager's performance. Are the returns realized by this stock-picking manager superior to the benchmark? Are the returns more volatile and is this volatility acceptable?
A private investor typically does not go out and hire multiple managers with one manager being assigned a mandate to outperform the S&P 500. More frequently they retain a manager with a broad mandate, such as purchasing large-capitalization value stocks. The manager has a focus on U.S. stocks but often has global exposure to round out the portfolio. If the manager outperforms or underperforms, can we confirm that the off benchmark differential explanation is stock picking ability or regional exposure?
When one hires a manager with a mandate of outperforming a specific index, there are a series of questions that can be asked:
How do they intend to outperform?
Do they intend to outperform by selecting only the very best stocks in the index and avoiding the balance or is market timing involved?
Will they tilt the portfolio to smaller capitalization stock to seek outperformance? Will this lead to greater volatility and less predictable investment returns?
Can they identify factors that led to outperformance in the past?
Historically we know that 86% of active large-capitalization fund managers have underperformed the S&P 500 (source, SPIVA 2021 report). Adding value is extremely difficult. This explains part of the reason that the simple purchase of indexes is seeing a huge inflow of capital. If you own the index, you are the benchmark.
Tim Morton, CFA is a recently retired portfolio manager with 45 years of experience working with private clients and is the editor of mortonir.com
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