How to Simplify Benchmarking
27 September 2021

Do you have a favorite set of benchmarks to compare your model portfolios against?

They can be used by both advisors and investors to set clear goals, manage expectations and address the level of risk that should be taken. 

However, choosing the appropriate benchmarks for your portfolio isn’t always straightforward.

Here’s how to think about the benchmarks you use to match up with client portfolios.

Do Advisors Need to Use Benchmarks?

The short answer is that yes—benchmarks fulfill an important role in tracking portfolios and keeping clients on track with expectations. 

Here are three reasons why.

Not using benchmarks can cause mismanagement of wealth 

It’s possible that not aligning a portfolio with a benchmark can cause a mismanagement of wealth, since there is no way to quantitatively measure how well a portfolio is performing without having a solid comparison to track its progress. 

It is also difficult to evaluate whether or not you should adjust your level of risk without being able to compare your portfolio against some kind of standard. Relevant benchmarks are needed for any investment portfolio in order to evaluate performance, risk management and strategy. 

Investment strategies are better explained and understood with the use of benchmarks

It can be difficult to explain investment strategies in a way that makes sense to the average investor if they begin a client-advisor relationship without high financial literacy. Finding a way to communicate complex concepts in a simple way is a necessity. 

Advisors can use benchmarks to show the similarities and differences between their investment strategies and the index that they have chosen, leading to better communication and a deeper understanding of their wealth management strategies.

Benchmarks help you understand if you’re making the right investment decisions

Making the right investment decisions isn’t a black and white issue. Being able to compare how your portfolio is doing against a similar model in the same time period is crucial to knowing when you need to adjust your strategy or level of risk. 

This is even more important in periods when markets are down so you can operate with a full understanding of the broader industry.

How Do You Choose Benchmarks for Your Strategies? 

Choosing the right benchmark for an investment strategy comes down to understanding what you’re trying to achieve in three core areas. 

Risk Profile 

Risk profiles contain information about an investor’s willingness and ability to take on risk. When building a portfolio, this is the number one consideration for most portfolio managers. There are multiple factors that determine risk profile, and a variety of different methods to create risk profiles—but matching a portfolio to a benchmark with a similar profile is an important step.

Asset Allocation

It’s self evident to any great advisor, but pitting a portfolio that’s only invested in international stocks against a benchmark that doesn’t include international stocks at all is a clear mistake. Most of the time, the examples won’t be so egregious. However, you still need to check that you’re matching up benchmarks to portfolios with asset allocations that align for comparison.

Time Horizon 

Differing goals and expectations for long-term and short-term investments might require multiple benchmarks in order to assess them properly. For instance, if you need to go back in time for analysis further than one benchmark allows, or if your investment strategy changed over time, you may want to use a similar index for your comparisons for a different time range to get the best comparisons.

How Do You Identify the Right Benchmarks? 

There are two ways to identify the right benchmarks to use. Choose from the standards, or construct your own blend.

Choose from Established Benchmarks

Established benchmarks, such as the S&P 500 and the Dow Jones Industrial Average, are obviously the standard. Choosing an established benchmark can become more problematic when you attempt to track changes to an investment strategy over time and you need to be more specific with your analysis. 

Build Your Own Investment Benchmarks

Building your own benchmarks requires the right software, and there is a slight learning curve. However, being able to create blended benchmarks for your investments can lead to a better understanding of your model’s expected performance and help you see how well your investment decisions have tracked against the wide markets. 

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