Serious investors benchmark their portfolios for several reasons. Here is a link to some benchmark basics and below are a few reasons for benchmarking.
- To know how well the portfolio is performing using an annualized calculation known as the Internal Rate of Return (IRR).
- To see how well individual parts or specific securities are performing within the portfolio.
- To see if the growth rate is increasing or waning with respect to broad benchmarks.
- To understand what risks are involved in the portfolio makeup and if diversification is reducing portfolio risk.
The TLH Spreadsheet is the best software program I know that will help to answer the above reasons, but also offers the opportunity to create a customized benchmark. The customized benchmark within the TLH Spreadsheet is the ITA Index. While the ITA Index has many benefits, it does contain a few flaws and one involves handling of cash moving in and out of the portfolio. While this is getting “into the weeds” of benchmarking, we might as well be as accurate as possible.
When cash moves in or out of the portfolio, these transactions are also handled for the three Vanguard index funds. For example, if $100 is added to the portfolio, the software also adds $100 to VFINX, VTSMX, and VGTSX so their IRR values are calculated properly. However, $100 is not added to each critical ETF representing an asset class such as gold, commodities, U.S. REITs, etc. Therefore, the ITA Index is not perfectly calculated when it comes to its IRR value.
What the ITA Index does do well is to show the investor how well the portfolio is performing compared to how well the portfolio would have done had the money manager been able to maintain the various asset classes compared to the Strategic Asset Allocation plan. I’ll likely write more on the importance of benchmarking later, but until then, be sure to read the few blogs on this subject.