New tools are helping individual investors build a better yardstick to gauge if their holdings are performing up to par.
Most investors compare their portfolio's performance to that of such well-known stock indexes as the S&P 500. The problem is that the S&P 500 measures just a slice of the overall stock market, and doesn't reflect the diversified portfolios that most individuals actually hold.
And as investors add more complex assets such as real estate and commodities to their traditional holdings of stocks and bonds, the S&P 500 and other well-known indexes have become even less reliable indicators of whether you're getting a reasonable return from your portfolio given the level of risk you're taking on.
Now, financial research firms are launching more-diversified indexes that better reflect how many people actually invest. For example, if you plan to retire in 2040, a recent "target-date" index lets you see how your holdings stack up against a model portfolio with a similar retirement-date horizon.
Meanwhile, some investors are designing their own benchmarks, using free online tools to build model portfolios of index mutual funds or exchange-traded funds, without even having to invest in the funds.
Investors who want an accurate picture of how their investments are doing need to select their benchmarks carefully. Simply outperforming, for example, doesn't mean much if you're using the wrong yardstick. Most stock funds beat the S&P 500 over the past five years, often by holding strong-performing small-cap and international stocks.
An appropriate benchmark also can show whether any fee you're paying for investment management is money well spent. Without good benchmarks, "you're flying blind," says Bud Green, a principal at Santa Monica, Calif.-based Fortress Wealth Management.
Even many mutual funds, which are required to compare their performance against a benchmark in the prospectus, often list an inappropriate index, says Berk Sensoy, assistant professor of finance at the University of Southern California's Marshall School of Business. In a study, Sensoy found that 42 percent of actively managed U.S. diversified stock funds listed a benchmark in their prospectus that didn't match their investment style. Some small-cap funds, for example, list the large-cap S&P 500 as a benchmark, while some mid-cap funds compare themselves against the small-cap Russell 2000 Index.
Financial advisers have long created custom benchmarks for clients, often using software and index data that cost hundreds or even thousands of dollars a year. Now, individual investors can more easily design their own custom index, and they don't have to spend big bucks to do it.
To build your own benchmark, the first step is to analyze how much of each asset class you hold in your portfolio, such as stocks, bonds, cash and other investments. Free online tools that do this are offered at the Web sites of many mutual-fund and brokerage firms. Investors also can use the free "Instant X-ray" tool under the portfolio tab at Morningstar.com. By entering the name of the funds or stocks you own, along with the dollar value of your holdings, the tool shows how your portfolio is divided among asset classes, such as stocks and bonds, and even stock styles, like large-cap growth or mid-cap value.
The next step is to build a custom benchmark by assembling a list of index mutual funds and exchange-traded funds that track the asset classes represented in your portfolio. To find out which funds track which asset classes, investors can use the data tool at indexuniverse.com or the mutual fund and ETF screeners at Morningstar.com. A boom in ETFs means these funds now track virtually every slice of the market, including high-yield bonds, real estate and emerging market stocks.
Finally, investors can use free portfolio-tracking tools available at sites like finance.yahoo.com or Morningstar.com to assemble and track their custom benchmark, along with their actual portfolio. If, for instance, your portfolio is 50 percent U.S. stocks, 20 percent foreign stocks, 15 percent short-term Treasury bonds, 10 percent real estate and 5 percent commodities, you might create a custom benchmark consisting of 50 percent Vanguard Total Stock Market Index fund, 20 percent Vanguard FTSE All-World ex-US Index fund, 15 percent iShares Lehman Short Treasury Bond ETF, 10 percent DJ Wilshire REIT ETF and 5 percent PowerShares DB Commodity Index Tracking ETF.
Some investors prefer the simplicity of benchmarking against the new breed of more-diversified indexes. Dorchester Capital Management Co., a financial-product firm in Houston, recently launched its Capital Markets Index, which tracks all U.S. investment-grade stock and bond markets as well as money-market instruments.
Currently the index, which can be accessed at www.cpmkts.com, has an asset allocation of about 55 percent stocks, 29 percent bonds and 16 percent cash. But Dorchester in coming weeks plans to launch a portfolio calculator that will let users customize the allocations to match their own. If your own portfolio is underperforming the total market with a similar asset allocation, it may be time to rethink your investments.
Other new, more-diversified indexes include "target-date" indexes launched by Dow Jones Indexes, a unit of Dow Jones & Co. (NYSE: DJ), which also publishes The Wall Street Journal. Like target-date funds, the indexes shift to a more conservative mix of investments as they approach their target retirement dates. Both Dow Jones Indexes and Lipper Inc. also offer "target-risk" indexes, which allows investors to compare their portfolios against others with a similar investment style, such as moderate or aggressive.
Once investors have found an appropriate benchmark, they should weigh its risk as well as its returns against their own portfolio. To do this, compare the benchmark's worst quarter for several years against your portfolio's worst quarter, suggests Craig Israelsen, associate professor at Brigham Young University. If your portfolio is lagging slightly behind the benchmark but suffered much smaller losses during the worst of times, you're probably doing pretty well, Israelsen says. But if your portfolio has lower returns and more risk than the benchmark, you might consider adjusting your asset allocation or switching to low-cost index funds, financial advisers say.