Using benchmarks to monitor investment performance fundamentally changes an investment strategy. As an example, designing a portfolio without a benchmark as a reference point becomes strictly an exercise in stock picking; picking stocks that you believe will increase in value. But without a benchmark to compare to the investor will not know if he was in fact doing a good job of picking stocks, or if the stocks were merely going up because the overall market was stronger.
It is important to understand benchmarks, how they are composed and the rules that are used to create them. If the goal is to outperform the benchmark then the investor’s portfolio is competing against the benchmark’s portfolio. As in sports the more you scout the other team, understand the team’s strengths and weaknesses, and their style of play, the more prepared you are to develop a strategy to beat the other team. As an investor you can choose who to put on your team.
If you have a stock portfolio of individual Canadian stocks and your benchmark is the S&P/TSX 60 Composite Index, then it becomes your team or portfolio versus the 60 players or stocks of the index. As well as picking good stocks and knowing how to weight then in your portfolio, understanding of the composition of the benchmark help investors outperform the index. In trying to beat the benchmark, it is just as important to know what not to include in the portfolio. In 2001 and 2002 when Nortel was a large component of the S&P/TSX Index and it was collapsing, the decision to underweight Nortel relative to the S&P/TSX Index meant the difference between outperforming the index versus underperforming
Understanding S&P/TSX Composite Index as a Benchmark
The S&P/TSX index is the index that most investors in Canada will use as a benchmark against which to compare their own equity portfolio. I am using it as an example of what a benchmark would look like. This is a very simplistic summary. More details can be found in the websites listed at the end.
The S&P/TSX Composite is the premier indicator of market activity for Canadian equity markets since its launch on January 1, 1977. With approximately 95% coverage of the Canadian equities market, it is the primary gauge for Canadian-based, Toronto Stock Exchange listed companies. The S&P/TSX Composite total market capitalization is over $1,300 billion in float market as of October 31, 2006.
Criteria for Index Additions
- Only stocks listed on the Toronto Stock Exchange are considered for inclusion in any of the S&P/TSX indices.
- Only the common shares or income trust units of Canadian incorporated companies are eligible.
- Stocks are assessed based on their float market capitalization. A company's float market capitalization is calculated by removing control blocks of 20% or more.
- Only stocks that are actively and regularly traded are considered for inclusion in the S&P/TSX composite index.
Sector Weights as Of October 31, 2006
| Sector |
Weight |
Number of Companies |
Consumer Discretionary |
5.26% |
28 |
Consumer Staples |
2.58% |
14 |
Energy |
28.25% |
76 |
Financials |
30.79% |
38 |
Health Care |
0.93% |
11 |
Industrials |
5.62% |
21 |
Information Technology |
3.41% |
10 |
Materials |
16.16% |
61 |
Telecommunication Services |
5.51% |
6 |
Utilities |
1.48% |
11 |
10 Largest Companies June 30, 2006
| Company |
Cap ($ mill) |
Weight |
Royal Bank of Canada |
58,286 |
4.51% |
| Manulife Financial Corporation |
55,743 |
4.31% |
| EnCana Corporation |
49,046 |
3.79% |
| Bank of Nova Scotia |
43,681 |
3.38% |
| Suncor Energy Inc. |
41,463 |
3.21% |
| Toronto-Dominion Bank |
40,783 |
3.15% |
| Canadian Natural Resources |
33,167 |
2.57% |
| Bank of Montreal |
30,097 |
2.33% |
| Barrick Gold Corporation |
28,406 |
2.20% |
| Petro-Canada |
26,891 |
2.08% |
There are a number of observations you can make about the composition of the index.
The index is a market weighted index, meaning that larger companies are more important to the performance than smaller companies. Although there are 276 companies in the index, the larger companies dominate. The top 10 largest companies make up over 31% of the index by weight.
The index does not accurately represent the size of the different sectors of the Canadian economy. For example, the top three sectors of the index - Financials, Energy, and Materials make up 75% of the index, but these sectors do not represent 75% of the economy.
The index is relatively risky, i.e. it is poorly diversified, and it is dominated by 3 sectors and the largest companies. Buying an ETF or mutual fund that tracks the index will have good performance when the top 3 sectors are doing well but will do relatively poorly when they are not. A portfolio that is more diversified might perform relatively poorly when the top 3 sectors are doing well and might perform well when they are not.
Summary
Most professional investors will use a benchmark to measure performance and most will have a good understanding of the benchmark they are trying to beat.
With a benchmark as a target, the investor can have one of two objectives. One objective is to invest in securities with goal to beat the benchmark. Another objective is to invest in securities that will have less risk than the benchmark. The use of a defined benchmark, simplifies the investing decisions because there is a specific target to aim for. In outperforming the benchmark, the securities not included in the portfolio are as important as those which are included.
Ken Hawkins
http://www.secondopinions.ca Detailed explanations of the S&P/TSX Index
TSXComp factsheet 
CanadianIndices Methodology
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