Playing the Benchmarking Game With Allan Roth
Benchmarking portfolios is part science and part judgment, which makes it susceptible to bias. Fortunately, there are ways to limit that.

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Benchmarking portfolios to evaluate their performance versus the market sounds simple enough, right? Think again.
That’s because benchmarking is part science and part judgment. With judgment comes bias, which allows portfolio managers to pick benchmarks that make them look good. It isn’t necessarily dishonest – it’s just human. Take, for example, an email from a fund wholesaler who was touting his fund’s performance: “7.1% return over the past year vs. ~5.1% for the Bloomberg AGG.” Is this a fair benchmark? The fund held over 45% junk (below a rating of BBB) while the Bloomberg Aggregate index is 100% investment grade and mostly backed by the US government. Junk bonds are highly correlated to stocks.
While the above example seems like trickery, it’s not that simple. Over the past 15 years, ending July 11, the iShares Core US Aggregate Bond ETF (AGG) has been bested by most of its peers, according to Morningstar. Many experts claim this proves active investing is superior when it comes to bonds. Yet, the category Morningstar uses to benchmark has about 2% junk and more BBB, the lowest category of investment grade. The category has far less US government-backed bonds. I don’t think Morningstar is tricking anyone. They’re merely using judgment.
Driving the Point Home
To understand benchmarking decisions, let’s take a non-investing example that we can all relate to: driving skills. Like the vast majority of drivers, I think I’m above average. My perception could be a demonstration of the “Lake Wobegon” effect, which is the human tendency to overestimate ourselves. One reason we can fool ourselves that we’re all above average is by using different standards (benchmarks). When it comes to driving, my benchmark is saving time, getting from point A to point B quickly, without endangering others or getting a traffic ticket. My wife’s standard is getting from point A to point B while following all laws, including the speed limit. My benchmark may be wrong, but being only human, I’m unlikely ever to admit it.
Building a custom benchmark using some of these indexes involves a ton of judgement. How granular should the benchmarks be? Should we benchmark a mid-cap-value portfolio against a mid-cap-value index? Should we benchmark a tech portfolio against a large-cap growth index? If we benchmark at the most granular level, it becomes more precise but also useless. Using Nvidia as an example, comparing performance against an index that’s made up of 100% Nvidia stock provides nothing of value.
What’s the Best Benchmark? Generally speaking, broader is better. The more granular the benchmark, the more likely the portfolio will perform exactly like the benchmark, which renders the performance analysis close to worthless. Fees should be included in the benchmark, but at the lowest level available for the appropriate index fund. A good approach is to use the total return (including dividend reinvestments) of the following five funds:
- US equities – Vanguard Total Stock Market Index (VTI)
- International equities – Vanguard Total International Stock Index (VXUS)
- US fixed income – Vanguard Total Bond Market Index (BND)
- Real estate – Vanguard REIT Index (VNQ)
- Private Equity – Public equity plus an illiquidity premium of 3% to 5% annually.
- Cash – Vanguard Federal Money Market Fund (VMFXX)
Vanguard funds are advantageous because they have been around the longest (giving more data to benchmark) and are among those with the lowest fees. These are returns that actually could have been achieved after considering costs. However, these benchmarks aren’t perfect. For example, a small-cap-value fund has significantly more risk than the broad US stock market. It’s good to point that out to clients, and advise them that they’ve been adjusted for these risk differentials. As for the earlier mentioned bond fund holding nearly half junk, it’s really a different animal. When dealing with such funds, let the client know that this holding defeats the purpose of fixed income, which is to be the shock absorber of a portfolio when stocks tank. Even during the great bond depression of 2022, bonds provided ballast.
Next, consider the weighting of the benchmarks. If you are doing a 10-year benchmark and the allocations changed over that period, how do you account for it? Say a buy-and-hold portfolio starts out at 60% equity and finishes the decade at 80% equity. It may be helpful to benchmark it against a portfolio of 70% equities or whatever it averaged during that period. That’s the average amount of equity risk over the decade for the portfolio.
Of course, these benchmarks and the weightings are extremely subjective. The main goal is to help think about selecting the appropriate benchmarks. The more difficult it is to determine the appropriate benchmark, the less likely the holding belongs in a portfolio. If you can’t explain the security to your client, rethink whether it’s appropriate.
What’s Your Bias? Bias is part of human nature, though we can work hard to minimize it in the subjective art and science of picking benchmarks. Advisors who say they have no bias, and always put their clients first, are sometimes the ones who are most abusing their clients. It’s not because they are evil, it’s because they aren’t questioning their own behavior and are blind to the conflicts of interests that we all face daily.
Advisors would, for example, have an incentive to use higher-performing benchmarks if we were analyzing a portfolio developed by someone else, especially if we had something to gain by showing underperformance. But if it’s a portfolio we recommended or put our client in, just the opposite would be true. To minimize bias:
- Select benchmarks ahead of time.
- Benchmarks must be consistent over time.
- Broader is better (total stock market index or total international stock market index).
- Match characteristics rather than using a narrow focus (market neutral, managed futures).
- Weighting should be set at the average over the time period benchmarked.
- Ask others you respect to comment on your benchmarks.
Because our clients deserve to know how their portfolio has performed relative to markets, there must be a high dose of science thrown in along with the art when selecting market benchmarks. Even the best advised portfolios sometimes underperform the benchmark. In that case, recommend buying the benchmarks; there may be holdings to keep due to tax consequences. In truth, it’s actually quite hard to beat properly selected benchmarks when fees are higher than those benchmarks used.