Choosing a Performance Benchmark


How do I go about choosing a performance benchmark for my Stock-Trak portfolio??


The key determinant of the performance benchmark that you should use is wever, to the extent that you believe that there may be other pervasive risk factors which determine long-run security returns, and to the extent that these risk factors are over-weighted in your portfolio, then you may wish to think about other performance benchmarks. the risk and return model that you believe drives the returns of the stocks in which you are investing. If we are sure that the Capital Asset Pricing Model determines the relation between risk and return, then all we have to do is to estimate the beta for our portfolio and adjust (net out) the portfolio returns for the risk-free rate of interest and our portfolio beta multiplied by the excess return (return less the risk-free rate) for a broad-based market index like the S&P 500 or the Wilshire 5000. To the extent that you picks your stocks somewhat randomly from the universe of available stocks, using the S&P 500 or the Wilshire 5000 as a benchmark and adjusting for the differential beta risk of your portfolio might well be adequate. <\P>

There is a fairly extensive literature that has developed in the Finance profession over the last 20 years that suggests that the Capital Asset Pricing Model does not completely describe the cross-sectional relation between risk and return (i.e., differences in beta do not seem to fully explain the observed differences in stock returns as the CAPM predicts). Therefore, to the extent that you believe that there may be other systematic/pervasive risk factors that are important in determining long-run security returns, and to the extent that these risk factors are over-weighted in your portfolio, then you may wish to think about other performance benchmarks (i.e., adjusting for your portfolio's beta risk may not be an accurate measure of your risk adjusted performance). For example, empirical evidence (more on this later) suggests that small equity capitalization firms outperform larger equity capitalization firms, and that low market price to book value per share firms outperform high market to book firms. A related issue is whether value stocks beat growth stocks or not. Precisely computing your portfolio's exposure to such risk factors is tricky. In practice this issue is sometimes dealt with by comparing the return for an actively managed investment portfolio with the returns for the subset of portfolio managers or mutual funds that follow a similar investment style. For example, if you are going to focus on 'value stocks' your performance benchmark could potentially be determined by placing your fund within the distribution of returns for mutual funds proclaiming a similar objective. <\P>

Further, apart from risk factors such as equity capitalizations and price to book ratios, we might argue that there are industry specific risk factors that cannot be easily calibrated. So to the extent that you choose to invest heavily in the stocks of a particular industry, you may want to directly compare your performance to the returns for the industry. For example, if you focus on the stocks of companies that manufacture semiconductors or stocks of companies in the defense industry, you could directly compare your performance to the respective performance of the SOX index or the DFX index, two sector performance indexes tracked by ETF's traded on the Philadelphia Stock Exchange. Of course you need to become knowledgable about these sector indexes if you plan on making such direct performance comparisons since the SOX index is a price-weighted index (like the DJIA) while the DFX is an equal-dollar weighted index.

You may also wish to develop your own composite benchmark index. For example, if your long-run strategy is to invest 60 percent of your capital in semiconductor stocks and 40 percent of your capital in defense stocks, then you could in principal compare the performance of your portfolio with the performance of a 'composite benchmark' that invested 60 percent of its capital in the SOX index and 40 percent of its capital in the DFX index.

In the end, my principal concern is that you think carefully about the performance of the 'passive alternative' to whatever investment strategy that you plan to follow. This comparison may be as simple as adjusting the return on your portfolio for your exposure to beta risk and the corresponding return for a portfolio that can reasonably be believed to have a beta of 1.0 such as the S&P 500 or the Wilshire 5000.


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