An important role in monitoring investment portfolio progress

By TIMOTHY J. McINTOSH; MBA, MPH, CFP®, CMP™ [Hon] 

Performance measurement has an important role in monitoring progress toward any portfolio’s goals.  The portfolio’s objective may be to preserve the purchasing power of the assets by achieving returns above inflation or to have total returns adequate to satisfy an annual spending need without eroding original capital, etc.

Whatever the absolute goal, performance numbers need to be evaluated based on an understanding of the market environment over the period being measured.

So, here is a brief review for our ME-P readers, doctors and subscribers; after a good market day today.

▲17,666.40 +305.36 +1.76%

Time-weighted Returns

One way to put a portfolio’s a time-weighted return in the context of the overall market environment is to compare the performance to relevant alternative investment vehicles. This can be done through comparisons to either market indices, which are board baskets of investable securities, or peer groups, which are collections of returns from managers or funds investing in a similar universe of securities with similar objectives as the portfolio.  By evaluating the performance of alternatives that were available over the period, the investor and his/her advisor are able to gain insight to the general investment environment over the time period.

The Indices

Market indices are frequently used to gain perspective on the market environment and to evaluate how well the portfolio performed relative to that environment.  Market indices are typically segmented into different asset classes.

Common stock market indices include the following:

• Dow Jones Industrial Average- a price-weighted index of 30 large U.S. corporations.
• Standard & Poor’s (S&P) 500 Index – a capitalization-weighted index of 500 large U.S. corporations.
• Value Line Index – an equally-weighted index of 1700 large U.S. corporations.
• Russell 2000 – a capitalization-weighted index of smaller capitalization U.S. companies.
• Wilshire 5000 – a cap weighted index of the 5000 largest US corporations.
• Morgan Stanley Europe Australia, Far East (EAFE) Index – a capitalization-weighted index of the stocks traded in developed economies.

Common bond market indices include the following:

• Barclays Aggregate Bond Index – a broad index of bonds.
• Merrill Lynch High Yield Index – an index of below investment grade bonds.
• JP Morgan Global Government Bond – an index of domestic and foreign government-issued fixed income securities.

The selection of an appropriate market index depends on the goals of the portfolio and the universe of securities from which the portfolio was selected. Just as a portfolio with a short-time horizon and a primary goal of capital preservation should not be expected to perform in line with the S&P 500, a portfolio with a long-term horizon and a primary goal of capital growth should not be evaluated versus Treasury Bills.

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While the Dow Jones Industrial Average and S&P 500 are often quoted in the newspapers, there are clearly broader market indices available to describe the overall performance of the U.S. stock market. Likewise, indices like the S&P 500 and Wilshire 5000 are capitalization-weighted, so their returns are generally dominated by the largest 50 of their 500 – 5000 stocks. Although this capitalization-bias does not typically affect long-term performance comparisons, there may be periods of time in which large cap stocks out- or under-perform mid-to-small cap stocks, thus creating a bias when cap-weighted indices are used versus what is usually non-cap weighted strategies of managers or mutual funds. Finally, the fixed income indices tend to have a bias towards intermediate-term securities versus longer-term bonds.

Peer Groups

Thus, an investor with a long-term time horizon, and therefore potentially a higher allocation to long bonds, should keep this bias in mind when evaluating performance.Peer group comparisons tend to avoid the capitalization-bias of many market indices, although identifying an appropriate peer group is as difficult as identifying an appropriate market index.

Furthermore, peer group universes will tend to have an additional problem of survivorship bias, which is the loss of (generally weaker) performance track records from the database. This is the greatest concern with databases used for marketing purposes by managers, since investment products in these generally self-disclosure databases will be added when a track record looks good and dropped when the product’s returns falter. Whether mutual funds or managers, the potential for survivorship bias and inappropriate manager universes make it important to evaluate the details of how a database is constructed before using it for relative performance comparisons.

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The Author

Timothy J. McIntosh is Chief Investment Officer and founder of SIPCO.  As chairman of the firm’s investment committee, he oversees all aspects of major client accounts and serves as lead portfolio manager for the firm’s equity and bond portfolios. Mr. McIntosh was a Professor of Finance at Eckerd College from 1998 to 2008. He is the author of The Bear Market Survival Guide and the The Sector Strategist.  He is featured in publications like the Wall Street Journal, New York Times, USA Today, Investment Advisor, Fortune, MD News, Tampa Doctor’s Life, and The St. Petersburg Times.  He has been recognized as a Five Star Wealth Manager in Texas Monthly magazine; and continuously named as Medical Economics’ “Best Financial Advisors for Physicians since 2004.  And, he is a contributor to SeekingAlpha.com., a premier website of investment opinion. Mr. McIntosh earned a Bachelor of Science Degree in Economics from Florida State University; Master of Business Administration (M.B.A) degree from the University of Sarasota; Master of Public Health Degree (M.P.H) from the University of South Florida and is a CERTIFIED FINANCIAL PLANNER® practitioner. His previous experience includes employment with Blue Cross/Blue Shield of Florida, Enterprise Leasing Company, and the United States Army Military Intelligence.

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Filed under: Investing, Portfolio Management | Tagged: •Barclays Aggregate Bond Index, •JP Morgan Global Government Bond, •Merrill Lynch High Yield Index, •Russell 2000, •Value Line Index, CMP™ Course, DJIA, EAFE, S&P 500 Index, Timothy J. McIntosh, Wilshire 5000 | Leave a comment »