Know your benchmark

My Benchmark

Perhaps not the most exciting first post for a blog, but let’s start from the beginning. Apart from talking stocks, investment ideas and probably other nonsense, I intend to run this site for a real money portfolio of stocks. This will be a concentrated portfolio of stocks from around the world.  Thus I need a yardstick to measure my performance/alpha. So let’s get that out of the way, so we later can move on to more fun topics. Since I intend to invest globally (mainly in the developed world), I have chosen MSCI World (Gross Return) as my benchmark, in this post we will get to know that index a bit better and by that understand the shortcomings of such a wide benchmark.


Choosing the right benchmark

As a long only investor it’s sensible to have something to benchmark your portfolios performance against. In the world of mutual funds it’s common to have an index that you benchmark against. This choice of index for most mutual fund managers becomes essential for their decisions and position taking. It will define when they have succeed at their job and when they have failed and in many cases they become afraid to deviate too much from their benchmarks. But for an active investor that does not hug closely to his index, it’s actually a difficult task to choose an index that will fairly measure up your investment results. Firstly you have certain styles in investing, Morningstar ranks funds into two camps, Value and Growth. The other axle in Morningstar’s world is size, meaning what is the Market Cap of the stocks you invest in, a fund is then plotted into this matrix as seen below.


This gives some granularity to styles the fund is running, for example if the fund is running Small Cap stocks with a Growth tilt and the Benchmark contains a Blend of Large Cap stocks. It’s then not really a fair assessment of the funds performance (I think you catch my drift). Keep in mind that there are many other style or style like factors that could explain out- or underperformance vs a benchmark. To mention a few: high/low Beta portfolio, High Dividend (or share buybacks), country/sector tilts or exclusions, Quality, Momentum and other “risk premia”. As you can see it becomes a daring task to measure any true alpha of fund/portfolio. I have worked a lot with this over the last few years, there are no holy grails, but I would like to make two important points:

1. Try to not keep any too obvious tilts in the portfolio. For example if your portfolio is Small cap oriented, chose a small cap benchmark (if available).

2. Decide what should be alpha, the general rule here should be, anything that varies over time is alpha, anything constant should be taken into account in the benchmark. If you are always buying European stocks showing Momentum and always disregard stocks in the Financial sector, your benchmark should be something like European Momentum Ex Financials. That might be hard to find and you need to settle for MSCI Europe Ex Financials. By that you have decided that your momentum strategy will be part of your alpha generation.

There could also be other shenanigans hiding in a benchmark, I would like to give a real world example. Consider the following case, you are running an Indian fund, following the UCITS guidelines, you have chosen the most common benchmark for international investors, MSCI India. The UCITS guidelines statuate that you can only hold 10% in a single stock. But the MSCI India benchmark has 2 stocks with approximately 10% weight in the benchmark. Consequently you can not take a positive view on these companies, you can at most, allocate 10% each and be aligned with the Benchmark, otherwise you will always be short (have a underweight vs benchmark) to these two stocks. Annoying indeed..

MSCI World Index (Gross Return)

For those of you wondering what does the “Gross Return” mean, it indicates that the price series includes all dividends paid out by the companies in the index.

“The MSCI World Index captures large and mid cap representation across 23 Developed Markets (DM) countries*. With 1,653 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.”

That’s straight from the horse’s mouth. Without delving deeper into the figures, a few things are clear just from the above information. An investor will easily have a very high active share vs benchmark as long as the stock portfolio is concentrated. The index focuses on Developed Markets, therefore a more adventurous investor will go “off” benchmark in terms of country exposure. Let’s dig a bit deeper than that, below is some stats for the index.


Ticking of the basics

Looking at the Average MCAP of stocks at 18.3b USD we are clearly dealing with a large cap dominated benchmark. But there are smaller companies too, even though they do not dominate the index. Given my investment style I don’t see the size factor as a major issue, I do from time to time dive into small/micro cap stocks, but I will run a all-Cap strategy.

Sector wise we have everything represented, although Materials, Telecom and Utilities will be very easy to overweight by just buying 2-3 positions in the sector. I will not exclude any sectors, although probably I have some sectors I invest less in due to my own lack of knowledge. This is also a non-issue.

First thing that worries me somewhat is looking at Country weights, The US clocks in on a whopping 59.1% benchmark weight – wow. I do intend to invest a large portion in the US, although it will vary over time, I’m doubtful if it ever will reach above 60%, so a constant underweight to the US, what does it mean?

The 59.1% issue

What implications does this then have? Well the last years it would have been disastrous, the US stock market has been extremely strong in combination with a formidably strong US dollar. I exemplify this through the main Swedish Benchmark OMXS30 denominated in dollar versus the MSCI World below and then how USDSEK has performed:



The orange line is showing the ratio of OMXS30/MSCI World and the last column is “Annual Eq” calculates the annualized USD returns for each Index for the period (5 years). As you can see Sweden kept up fairly well until mid 2014 when the USD started its world crusade, after that Swedish investors got left in the dust. A Swedish investor might not feel so poor though, since they would calculate their performance in SEK. Anyhow, this clearly shows the dilemma of having a 59.1% weight towards the US in your benchmark, you basically need to get the US right to outperform (or in this case, keep up with) MSCI World.

First conclusions

The country allocation is not ideal with 60% weight to the US-market, on other basic metrics the index looks OK. Like i tried to exemplify above it’s not easy to find one single Index that represents your investment style well, if you don’t shape your investment style towards the benchmark, which I don’t intend to do, I want to invest unconstrained as possible. Although I have a fairly good idea in my head what my portfolio will look like, it is still yet to be fully defined. when I have been running my portfolio for a year and my investment style is more clear it might be time to revise my benchmark and dig deeper, for now I conclude MSCI World will do. This is not a final decision but a starting point

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