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A Universal Portfolio Performance Benchmark


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By Leland B. Hevner
President, National Association of Online Investors (NAOI)

As a teacher of personal investing at the college level for close to two decades, I am constantly asked by students to review the portfolios they hold and assess their performance. I look for obvious problems related to inappropriate investments and/or those with excessive fees. But it is very difficult to determine if a portfolio’s performance is good, bad or just mediocre. The problem is the financial industry today uses Modern Portfolio Theory (MPT) methods to create portfolios that are customized to match each investor’s risk tolerance level making a universal performance benchmark impossible.

In this article I describe a portfolio performance-benchmark that solves the problem. It enables the quick and easy evaluation of the effectiveness of any portfolio for a specified time frame.

Performance Benchmarks in Use Today

Investment performance benchmarks used by the investing industry today are not adequate portfolio evaluation tools. The most commonly used benchmark is the S&P 500 index. But this index provides information for only the stock asset class. It cannot be used to effectively evaluate the performance of portfolios that contain both stocks and bonds. A second benchmark frequently used is a standardized 60% Stock / 40% Bond, asset-allocation portfolio. The problem with this benchmark is that it is only useful when evaluating portfolios with the same asset-allocation.

The investing world needs a portfolio performance-benchmark that measures the effectiveness of any portfolio. It does not exist today. The discussion below shows how the NAOI created one.

Requirements for a Universal Portfolio Performance Benchmark

To serve as a universal performance benchmark, a portfolio needs several qualities. Unlike MPT-based portfolios that have as their goal to match the risk tolerance of each investor, it must have the universal goal of capturing the positive returns that exist somewhere in the market at all times and with minimal risk. To do this it must be market-sensitive; capable of changing its asset allocation based on objective observations of market data and not on subjective human judgments. It must also be a portfolio that is simple to understand and easy to implement and manage by investors of all experience levels. And, most importantly, it must be a portfolio for the masses, not one customized for each individual investor.

Using NAOI Dynamic Investments

To create the benchmark portfolio described above, we used a new approach to investing created by the NAOI called Dynamic Investment Theory (DIT) and a new investment type it creates called Dynamic Investments (DIs). Both are described at this link on the NASDAQ site and in more detail on the NAOI Web site at this link.

Dynamic Investments (DIs) have these components:

  • Dynamic Equity Pool (DEP) – This is where a designer places multiple ETF or Mutual Fund “candidates” for purchase by the DI at predefined Review periods.
  • Review Period – This is how often a DI ranks the ETFs in its DEP to identify the one that is trending up most strongly in price. The “winner” is the one ETF that is purchased and held until the next Review.
  • Price Trend Indicator – This is the technical indicator used to rank the ETFs in a DEP at a Review.
  • Trailing Stop Loss – For each ETF purchased a Trailing Stop Loss is used to protect its value during the short period when it is held.

The DI management process uses a standard set of rules, set by Dynamic Investment Theory, to make trade decisions based on the objective observation of price trend data. No human judgments are involved meaning that the process is easy for any individual investor, or advisor to perform on their own or it can be automated.  Below you will see how DIs enable the creation of NAOI Dynamic Portfolios - the investment type needed to create a universal portfolio performance-benchmark.

Creating a Dynamic Portfolio

Today’s MPT-based, asset allocation portfolios employ a buy-and-hold management strategy. As a result, these portfolios are “static”, having no sensitivity to market changes and thus not capable of taking full advantage of the positive returns potential that is available somewhere in the market at all times . To capture this potential a “dynamic” portfolio is needed that is capable of changing the equities it holds, and thus its asset allocation, based on a periodic review of market trends. We do this by inserting a Dynamic Investment into an MPT portfolio structure as discussed next.

The NAOI Universal Portfolio Performance-Benchmark

Extensive testing by the NAOI has shown that the following portfolio configuration is optimal for a universal portfolio performance-benchmark. Any investor, or advisor, can easily implement and manage it. And because no subjective judgments are involved, it can easily be automated.

Below are the building blocks and allocations of the portfolio (note that “static” means buy-and-hold):

  • 50% Dynamic Investment with both a Total Stock Market and a Total Bond Market ETF in its DEP
  • 25% Static Stock ETF (this is typically not the same Stock ETF used by the Dynamic Investment)
  • 25% Static Bond ETF (this is typically the same Bond ETF used by the Dynamic Investment)

The portfolio is reviewed on a quarterly basis at which time the manager (or computer if automated) determines which ETF the DI will purchase (or retain if already owned) and hold until the next Review.

At all times this portfolio will hold one Bond ETF and one or two Stock ETFs. Thus, when Stocks are trending up the allocation will be 75% Stocks / 25% Bonds. When Bonds are moving up the allocation will be 25% Stocks / 75% Bonds. This “market-bias” is illustrated in the diagram below:

Always keep in mind that portfolio changes are signaled automatically based on objective observation of market data – not on subjective human judgments that are the source of so much that is wrong with investing today.

Historical Performance of the Universal Benchmark Portfolio

The table below shows the performance of four different benchmark types for the 11-year period from the start of 2008 to the end of 2018. Shown for each are the Average Annual Return for the period along with a Sharpe Ratio – this is a measure of how much return was achieved for each unit of risk taken and the higher the better. The NAOI Portfolio Performance-Benchmark is shown in the bottom row.

Investment

2008-2018

Avg. Annual Return

Sharpe
Ratio

S&P 500
Stock Index

+7.2%

0.37

Long-Term Treasury
Bond Market

+5.8%

0.38

60% Stock / 40% Bond
MPT Portfolio

+7.9 %

0.64

NAOI Universal Portfolio
Performance-Benchmark

+15.6 %

1.16

You can see that the performance of the Benchmark Portfolio is almost double that of the MPT portfolio for the period tested. And these results were achieved using just three ETFs with a very simple and easily automated portfolio management process.

What about the Risk Tolerance Factor?

The Benchmark Portfolio doesn’t care about any investor’s risk profile. It has the universal goal of maximizing returns while minimizing risk in all economic conditions. All investors want to achieve this goal. But this doesn’t mean that it ignores the risk issue. This portfolio is far less risky than virtually any MPT portfolio based on the following factors:

  • Company and Asset Diversification – Both MPT portfolios and NAOI Dynamic Portfolios utilize these risk reduction factors.

Only NAOI Dynamic Portfolios use these risk reduction factors:

  • Time Diversification – A periodic review of the Benchmark Portfolio’s holdings is mandated, and changes made, according to rules set by Dynamic Investment Theory (DIT).
  • Method Diversification – The Benchmark Portfolio uses both a buy-and-hold strategy (MPT) and a buy-and-sell strategy (DIT) making it methodology-diverse.
  • Reduction of Subjective Judgments – The Benchmark Portfolio does not use subjective human judgments in the portfolio management phase; removing a massive risk element.
  • Stop Losses – Investors want absolute protection from market crashes. The use of Trailing Stop Losses as a part of the Benchmark Portfolio design gives it to them and eliminates a significant risk element that MPT portfolios are exposed to.

The effects of these additional risk reduction elements are reflected in the significantly higher Sharpe Ratio of the Benchmark Portfolio as shown in the above table.

Summary

The NAOI Universal Portfolio Performance-Benchmark described in this article can be used to quickly evaluate the performance and effectiveness of any portfolio. This is made possible by the fact that it has a goal that all investors want to achieve, namely maximizing returns while minimizing risk in any economic condition. Its returns can be earned by any investor who holds this portfolio without regard to their risk tolerance. And it is extremely simple to implement and manage.

All investors can, and should, periodically ask the question: “If the portfolio I hold is producing returns lower than the NAOI Benchmark Portfolio, why shouldn’t I replace my current portfolio with it?”. Giving investors the tool they need to ask, answer and act on this question is the purpose of the NAOI Universal Portfolio Performance Benchmark described here.

The performance of the NAOI Portfolio Performance-Benchmark is updated quarterly on the NAOI.org Website. Contact the author at LHevner@naoi.org for more information.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.









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