Benchmarking your investments - now and forever

As I write this introduction on June 13, the stock markets have recovered spectacularly from their March lows.

Whether they continue to climb is subject to debate. Some market watchers think the recovery will be quicker than expected. They remind us that the indexes are made up of several large companies that have weathered the COVID storm to date. Those companies will also likely benefit in the near term, as they will be able to acquire less fortunate companies at attractive prices. These market watchers suggest the markets are just reflecting the future.

Others think the markets are not reflecting reality either currently or down the road, as consumer spending will be dampened for years. I have no idea who is correct, and I am not sure anyone really does.

Today’s blog post on benchmarking was initially conceived by my colleague Carmen McHale to be an education piece on what benchmarking is and how it can be used. It morphed, however, to include some discussion on benchmarking and COVID.

I have read and been inundated with articles, commentary and newsletters on investing during COVID and have been considering how my clients and I have fared during COVID. As you will quickly realize after reading Carmen’s post, benchmarking is not as simple as it seems. Neither is finding the right benchmarks for your investments. A 60% equity/40% fixed income portfolio can vary widely. The 60% can be all equities, mostly U.S., an even mix across Canada, U.S. and international, or 40% equities, 10% hedges, 10% real estate; and the 40% fixed income can be all bonds, or bonds and preferred shares (personal pet peeve, I don’t like preferred being classified as fixed income, but that is a topic for another day). So finding an apples-to-apples benchmark is very difficult.

So how does one benchmark their advisors’ investment returns (if they are not provided appropriate comparisons by their advisor) during COVID – or their own for that matter? Personally, I like the suggestion made by Ian McGugan in a recent Globe and Mail article (if you are not a Globe and Mail subscriber, access to the article may not be available).

While Ian’s article is on constructing a portfolio going forward, he makes a valuable remark near the end of the article on balanced portfolios: “even if you conclude these products aren’t right for you, they can provide a good baseline for comparison with other approaches in these unclear, unsettled and unknowable times.” For the week ending June 12, I looked at the year-to-date returns of a few balanced funds (typically 58% equity/42% bond or so) and their YTD losses ranged, but were about 1.6% on average. As Ian says, these may not be appropriate funds or benchmarks for you, but they are good baseline comparatives.

I think this just became my most long-winded introduction in the history of the blog, so without further ado, here is Carmen.

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By Carmen McHale


A benchmark is information that helps you compare the performance of your investments. I tell clients that if they are going to pay someone to manage their investments, they should expect to get returns that are at least as good as the benchmark after fees.

Indexes such as the S&P 500 are common benchmarks to assess investment performance. In fact, some investors invest through mutual funds or exchange traded funds that simply follow the index – this is often called passive investing.

By comparing your performance against a relevant benchmark index, it is possible to see how much value an active manager adds (or does not add) over a passive approach. It allows you to evaluate the performance of your portfolio and how much of the total return comes from investment decisions that were made by the advisor versus the movements of the financial markets overall.

Benchmarking for risk

When comparing your returns against the benchmarks, it is equally important to see how much risk your portfolio is taking verses the benchmarks. Benchmarking for risk allows you to see how consistent the returns are over time, and can give you an idea of if your investments are taking on more risk than the benchmark.

Risk can be measured in many ways. However, I personally like to use standard deviation, as most investors can easily understand this metric, and it is published by most mutual funds. A fund with higher standard deviation has more price volatility, while a lower standard deviation tends to produce returns that are more predictable.

See this example of balanced fund returns over the last five years. In this fairly typical case, the portfolio consists of 35% fixed income, 32.5% Canadian equities, 27.5% global equities and 5% cash.

Year	Portfolio Return (Net of fees)	Benchmark Return
2015	5.33%	3.87%
2016	5.86%	8.32%
2017	9.54%	7.88%
2018	-1.66%	-2.26%
2019	16.73%	15.65%
5 -YEAR AVERAGE	7.16%	6.69%
STANDARD DEVIATION	6.71%	6.57%
Range of returns at 1 Standard Deviation	0.45% to 13.87%	0.12% to 13.26%
Range of returns at 2 Standard Deviations	-6.26% to 20.58%	-6.45% to 19.83%
Range of returns at 3 Standard Deviations	-12.97% to 27.29%	-13.02% to 26.4%

The standard deviation of this portfolio is 6.71% while the standard deviation of the benchmark over the five years was 6.57%, but what does that mean?

Standard deviation explained

From a high level, it is apparent that this portfolio manager managed to get higher average returns over the five years, despite taking on similar risk as did the benchmark.

Now think back to your statistics classes. If you can’t quite recall the details, here’s a refresher on the basics of standard deviation. When assessing how much risk you have in your portfolio, it is wise to look at three standard deviations so you can get an idea of the potential downside you could experience in any one year (like the beginning of 2020). Here’s what three standard deviations mean with our portfolio and benchmark:

• One standard deviation - If the data behaves in a normal curve, then 68% of the data points will fall within one standard deviation of the average, which means 68% of the time your portfolio should produce returns between 0.45% and 13.87%, while the benchmark should produce returns between 0.12% and 13.26%.
• Two standard deviations - If you want to capture what happens 95% of the time, you go to two standard deviations from the mean. Returns should fall between -6.26% and 20.58%, while the benchmark should produce a range from -6.45% to 19.83%.
• Three standard deviations - How about the other 5% of the time? Take it to three standard deviations to get 99.73% of the time – which means your portfolio in any given year should return between -12.97% and 27.29%, while the comparable benchmark should produce a range between -13.02% and 26.4%.

To keep matters, as simple as possible, I like to boil it down to one number to compare by dividing the five-year average return over the standard deviation (return to risk ratio):

                    Portfolio return/risk = 106.71%; Benchmark return/risk = 101.83%.

The higher the ratio, the better, so our model portfolio should perform well against the benchmark.

Our typical portfolio during COVID-19

The onset of COVID-19 can be considered an extreme shock to the economic environment, so let’s examine how this typical portfolio performed against the benchmark during this time.

The same portfolio example above had a negative return of -8.94% as of March 31, 2020 compared to the benchmark return of -9.44%. The returns of the portfolio were well within three standard deviations (-13.02% noted above). The portfolio not only has superior returns when they are in positive territory, but also demonstrated less downside in a volatile market environment.

Minimum acceptable return

When benchmarking investments for my clients, I also like to calculate something called Roy’s Safety-First Ratio, or simply SFRatio. This allows clients to see what would happen if their investments perform at less than expected returns. To do this, we create a minimum acceptable return, or threshold return. By fixing a minimum return, an investor aims to reduce the risk of not achieving the investment return.

Let’s imagine your financial plan indicates a minimum required average return of 4.25%. Now you have three portfolios to choose from:

• Portfolio A: expected return - 13%; standard deviation - 20%
• Portfolio B: expected return - 9%; standard deviation - 11%
• Portfolio C: expected return - 8%; standard deviation - 6%

Which portfolio should you choose?

If you want to have the portfolio that has the highest likelihood of meeting your required return, you can calculate the SFRatio. Here is that formula:

• Expected return of the portfolio; minus 
• Minimum required return; divided by 
• Standard deviation of the portfolio. 

Using this formula, here are your three SFRatios for these portfolios:

• Portfolio A: (13% - 4.25%)/20% = 0.4375
• Portfolio B: (9% - 4.25%)/11% = 0.4318
• Portfolio C: (8% - 4.25%)/6% = 0.625

As you can see, Portfolio C has the highest SFRatio, and therefore has the highest probability of earning the investor their required rate of return.

Benchmarking during COVID-19

These days, financial projections are a bit of a tough call. It’s not just that the economy may look quite different in the next five to 10 years from its profile over the past decade. It’s also that their impact on the markets is difficult to predict.

Benchmarking for performance during COVID-19 is as relevant as it’s ever been. The benchmarks you use should cover the same periods of time, and you will see how your investments perform against other potential investments.

The true difference-marker during COVID-19 is benchmarking for risk. With volatility so high, risk skyrockets, so keep on the eye on the ups and downs of your investments. If there ever was a time to know that your portfolio is taking on more risk than the benchmark, COVID-19 is that time.

For more in investing during COVID-19, check out this recent roundtable discussion on protecting your wealth in the COVID-10 economy.

The content on this blog has been carefully prepared, but it has been written in general terms and should be seen as broad guidance only. The blog cannot be relied upon to cover specific situations and you should not act, or refrain from acting, upon the information contained therein without obtaining specific professional advice. Please contact BDO Canada LLP to discuss these matters in the context of your particular circumstances. BDO Canada LLP, its partners, employees and agents do not accept or assume any liability or duty of care for any loss arising from any action taken or not taken by anyone in reliance on the information on this blog or for any decision based on it.

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Your Investment Return - What Is It Telling You?

I find it shocking, how many people have no clue what their investment returns are for any given year let alone their historical returns. Some investment firms have been purposely opaque in respect of reporting investment returns for their clients. It is hoped that with the introduction of CRM2 (see this article) there will be far greater transparency in respect of the returns generated on your investments and the fees you pay your investment firm.

As of December 31, 2016, your investment statement should start reporting a personal rate of return. From what I understand, the reporting of your returns will only be mandated for 2016 and prior year investment returns do not have to be reported (some investment advisors/managers are very lucky; as 2016, the first year of reporting was a strong market year and this may allow them to hide poor past performance - thus, I would also request personal return information for the last three years, the last five years and since inception in addition to the 2016 return information). While your statements will not necessarily provide index benchmarks for you to compare your return against, at least you will have a return number!

If you have an investment advisor or investment manager and they have not reviewed your returns and strategy on a yearly basis before this required reporting, I would put them on notice you are disappointed and expect far more going forward. In addition, you should also review the investment fees you paid in 2016, which should also be provided on your statement. If you manage your own investments, you should be reviewing your performance on a yearly basis, or you are doing yourself a disservice.

Okay, enough with my rant. Today I actually intend to talk about what your investment returns are actually telling you about your investment strategy and investment policy and whether you are adhering to your strategy or chasing returns. (As an aside, if you are a good writer, you always tell your audience what your intended topic is within the first couple lines, you do not wait until the fourth paragraph. So do as I say, not as I do :).

Your Investment Strategy

When you engage an investment advisor or investment manager etc. the first thing that should be done is to create an investment policy statement and strategy based on your needs and risk. This will include a target allocation between fixed income and equities and target allocations between different asset classes and global diversification among other considerations. You should also be provided benchmark indices to compare your fixed income, Canadian, U.S. and World allocations against; unfortunately, this is often not provided.

For this post, let’s assume for simplicity sake that you want an asset mix of 30% fixed income and 70% equity which is allocated 30% Canadian, 30% World and 40% United States.

What Are Your Returns Telling You?

For purposes of illustration, I am going to use 2015 stock market returns since there were some of the larger variances within portfolios I have seen in years (I personally observed returns ranging from up 12% to down 17%). I will only briefly comment on 2016, since most statements are just being mailed.

So why the wide variance in returns in 2015? The reason was simple. The Canadian markets and resource stocks in particular were weak and preferred shares, especially rate reset preferred shares (due to low interest rates that were not contemplated when the shares were issued) were hammered. The TSX ended 2015 down around 11%. The U.S. market was down around 3% or so (but there was a huge foreign exchange gain where you held U.S. stocks because of the increase in the U.S. dollar relative to the Cdn dollar). World markets were also fairly weak.

So I ask you. If you had a 3-5% return in 2015, was that good or bad? This is a loaded question. If your allocation was the 30/70 mix I note above, that was probably somewhat expected and almost all due to the 30% or so increase in the U.S. dollar. Is that good investing or proper fund allocation? I would say a bit of both.

I noted that I saw people with losses as high as 17%. Was this bad? The answer surprisingly could be yes or no. If you had a large Canadian equity allocation with a resource bent (some people believe in investing most of their funds in the country they will live and retire in) then, the 17% loss may not have been as bad as your initial reaction and somewhat expected. That same portfolio will have exploded to the upside this year. Personally such a portfolio has too much volatility for me, but it may have been in adherence to that person’s investment strategy. Where you had a 17% loss because of rate reset preferred shares the investment industry sold and pushed (especially to seniors), but did not understand, that is another story.

For those people who had a 12% return in 2015, these returns were solely because they were over-exposed to U.S. stocks. I would say those returns, while excellent, were gained at the expense of risk (too much U.S. stock allocation) and you would have to understand the downside risk on a reversal in the dollar.

Some people told me their advisors did a great job over-allocating to the U.S. in 2015 and they were scaling back in 2016 (these conversations were in early 2016) to protect against a F/X reversal. When I hear comments such as the above, I cringe, since this says to me that their advisor has not created a disciplined strategy, but is stock picking, which more often than not, ends up badly.

2016 Returns

This year both the Canadian and U.S. markets have done very well. So if we look at the sample portfolio, one would expect a return somewhere between 8-11%. If you are this person and your returns are 18% I would want to understand why I outperformed far greater than my expected asset allocation. A better than expected return may indicate something amiss with your investment mandate. The same goes if your return was 6%, why were you below your expected return?

In conclusion I suggest the following:

1. Ensure your investment advisor/manager provides you with current and historical returns don’t just accept the 2016 returns that will be on your December, 2016 statement. Meet with them to discuss your returns and compare them to your intended strategy and investment policy and compare your returns to benchmark indices you agree upon. Ensure the returns you are provided with are net of management and investment fees and that the returns are not varying significantly from your expected returns. Variations both up and down may be cause for concern.

[BTW: If you are unhappy with your advisor and looking for a change, let me know. Depending upon your asset base, I or a colleague, may be able to assist you with financial planning and investment oversight and provide you access to several investment managers I work with directly (as an accountant I cannot provide specific investment advice, so I must work with an investment manager)].

2. If you manage your own investments, ensure you have created an investment strategy that it is written down and then compare your returns to what you expected and ensure you kept a disciplined approach in line with your strategy.

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation.