Determining Your Own Absolute Benchmark.
Imagine you are saving for your retirement. A financial plan considers all of the factors that have a bearing on your long term financial security. The plan will consider the assets you have today, the amount you want to spend in retirement, the income you will earn before retirement, the number of years before retirement, the amount you can save, the income tax you can expect to pay, your life expectancy, your pension income, and the size of the estate you want to leave. When all of these numbers are entered into the computer the financial planning program will show you the average rate of return you need to earn in order to have everything work out as you desire.
The rate of return that is required to make everything balance out is your absolute return benchmark. For this example let’s assume your absolute return benchmark, as determined by your financial plan, is 7%.
Calculating a Customized Relative Performance Benchmark
Most investors, whether they own mutual funds or individual securities, will have investments in more that one asset class. Using a single benchmark like the S&P/TSX composite would not be appropriate if the portfolio is 12% cash, 36% fixed income and 52% Canadian stocks. It would be like comparing apples to oranges. Investors who invest in multiple asset classes need to calculate their own customized benchmark.
Creating a customized benchmark requires that you know:
- The asset classes that should be used for the long term asset mix.
- The appropriate allocation among the asset classes that are going to be used.
- The benchmarks that should be used for each individual asset class.
- Data that shows the total return for each individual benchmark.
Consider an investor with a long term asset allocation using 10% cash, 30% fixed income, 35% Canadian equities, 15% U.S equities and 10% non-North American equities. An appropriate customized benchmark could be the composite of the returns of each index as follows.
| 10% |
Scotia Capital 91 day T-bill Return |
| 30% |
Scotia Capital Bond Universe Return |
| 35% |
S&P/TSX Composite Return |
| 15% |
S&P 500 Return in Canadian Dollars |
| 10% |
MSCI EAFE Return in Canadian Dollars |
To calculate your actual benchmark return you would multiply the percent that is in an asset class (e.g., 35% in Canadian stocks) by the return of that individual benchmark index, and then add the products of these calculations. See example below:
| Allocation |
Asset class |
Appropriate benchmark Index
|
Benchmark Return |
Product |
|
| 10% |
Cash |
Scotia Capital 91 day T-bill |
4% |
.4% |
| 30% |
Fixed Income |
Scotia Capital Bond |
5% |
1.5% |
| 35% |
Cdn Equities |
S&P/TSX Composite |
10% |
3.5% |
| 15% |
US Equities |
S&P 500 Cdn $ |
8% |
1.2% |
| 10% |
Intn. Equities |
MSCI EAFE Cdn $ |
10% |
1% |
|
| 100% |
|
|
|
7.6% |
In this example your benchmark index is 7.6%
When an investor compares the performance of their portfolio against a composite benchmark, it will give a cleaner picture of how well they are doing. Further analysis would allow the investor to understand the reasons for the performance relative to the composite benchmark.
Ken Hawkins & Warren MacKenzie
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