“How much did my investments make last year?” is naturally an important question for any investor. There is another question, however, that I believe should be asked just as frequently: “How did my investment returns compare with other similar investments?.”
Unfortunately, many investors fail to compare their individual returns with any type of benchmark that could help them compare to what the overall market returned for similar risk-level investments. The overall market can be broken down into asset classes² such as large-cap stocks, small-cap stocks, international stocks, emerging market stocks, government bonds, commodities, public real estate, and several others. The collective returns of a particular asset class are shown through indexes.¹
An asset class is a group of securities that share similar characteristics, perform comparably in the marketplace, and are governed by the same laws and regulations. Major asset classes include stocks, bonds, cash, real estate and commodities.
¹An index is a measurement used to calculate the average weighted returns of various asset classes and subsets of asset classes such as stocks, bonds, real estate, commodities, etc.
²An asset class is a group of securities that share similar characteristics, perform comparably in the marketplace, and are governed by the same laws and regulations. Major asset classes include stocks, bonds, cash, real estate and commodities.
To use an analogy to describe a benchmark or index, think of real estate “comps” which compare similar residential values in a given area or region. A prospective buyer or seller will research the comps to determine the general price level of a home which is similar in size, age, location, etc. But you cannot invest in the comp because it doesn’t represent ownership of anything, it’s only a collective measurement of value for informative purposes.
In the capital markets (universe of investments), there are several indexes published by various companies including stock indexes, bond indexes, real estate indexes, and commodity indexes. As with the real estate comps, the direct investment in published indexes is not possible; it’s not a tangible thing. Mutual fund companies however, can create their own version of a related index by closely duplicating the published indexes and offering them to investors as mutual funds or ETF’s (i.e., Vanguard 500 Index™).
Assume Investor X owns 4 investments that were purchased from company A:
Company A Large-Cap Mutual Fund 20.0%
Company A Small-Cap Value 14.75%
Company B Corporate Bond Fund -3.50%
Company C US REIT Fund 26.25%
**Company and funds are hypothetical and do not represent any actual performance results for any client of Carr Wealth Management, LLC.
Investor X would like to compare his results with a benchmark that represents the particular asset classes he owns. Below is his return and the corresponding index return according to above chart.
(Hypothetical) (From Above Chart)
Investor X 2021 Return Related 1 YR Index Return
Company A Large-Cap Mutual Fund 20.0% 26.45%
Company A Small-Cap Value 24.75% 28.27%
Company B Corporate Bond Fund -3.50% -.99%
Company C US REIT Fund 26.25% 35.10%
Since the index returns are not derived from an actual fund, there are no expenses associated with the index returns shown above. Investor X in the above example was paying fees for the access to capital markets in the form of advisor fee (or self-directing), brokerage fee, transaction fees, mutual fund fees including fund manager fees, and other related investment costs. It is possible to still beat the market with all the fees but not probable. On average, two-thirds of actively managed funds do not outperform their benchmarks, and the reason is mainly the additional unnecessary costs. But a careful analysis may reveal that your investments are lagging the market returns by more than just the costs of your funds. In this case, it may make sense to research further to identify the reason.
It will not always be possible to compare your investments with a benchmark due to the inability to identify which asset class your investments should be labeled, such as “balanced funds, asset allocated funds, target date funds, and other investments that don’t separate asset classes or whose name is not clearly identified to a particular asset class. If you are serious about tracking your returns to what the market yields for similar investments, asset class funds (large-cap, small-cap, etc.) should be considered for better comparison to indexes.
If you would like to discuss your portfolio or help with comparing your results with appropriate benchmarks, please feel free to contact us to schedule a no-charge consultation with Anthony B. Carr, CPA, CFP.
**Past Performance is no Guarantee of Future Results
Investments involve risks. The investment return and principal value of an investment may fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original value. Past performance is not a guarantee of future results. There is no guarantee strategies will be successful.