Measuring Performance - How to Choose the Right Benchmark

The main goal for most investors is to outperform the market. But what exactly is the market? And is beating the market even the right goal? That's what we discuss today.

A couple of days ago I wrote about my portfolio and the performance YTD. As benchmarks, I used the S&P 500 and the MSCI World Index. These indices have almost zero overlap with my portfolio, and I use a totally different strategy.

Because of that, I received questions about why I didn’t take indices that better resemble my strategy or portfolio. If I had taken small-cap indices, I wouldn’t have had similar returns to the market but beaten it by a wide margin since they performed much worse than the S&P, MSCI World, or my portfolio.

But I don’t think that’s how you should approach benchmarking. I know that many funds do this. They choose benchmarks that supposedly(!) resemble their portfolios and strategies instead of the major indices.

The S&P 500 and why many don’t use it as a Benchmark

This has benefited them in recent years since indices like the S&P 500 and NASDAQ are among the strongest performers, and almost every other index is far behind. This is mostly because the top 5 to 10 holdings drive the majority of returns.

This chart compares the Magnificent 7 to the rest of the S&P 500. As you can see, the difference is huge year-to-date—about 10%. This is not unique to 2024; it has been happening for years.

Because of the Magnificent 7's remarkable performance over recent years, and therefore the S&P 500, many fund managers prefer to use different benchmarks and argue that they have a different strategy that cannot be compared to the S&P 500 (or the Magnificent 7).

I don’t think you can do this in the long term.

My Problem with using different Benchmarks

What matters most is not your strategy but what alternatives you have to invest in. You should base your investing strategy on what you think will have the best returns going forward. If you’re right, you should outperform the broad market (because your theme or niche outperforms). And if you’re good at executing, you should then also outperform the indices in your niche (because you pick the biggest winners).

If you (in the long term!) only outperform the indices in your niche but not the broader market, then you have simply chosen the wrong strategy.

You always have the option to just invest in the broader market. For US citizens, that’s probably the S&P 500. For people outside the US, this can be your national stock market index, or you choose an index covering the entire world.

And by that logic, your alternative is always one of the major indices. Thus, it should ultimately also be your benchmark. This might be uncomfortable when the index performs over 20%, but that’s the current reality.

That’s why I said I’m happy with the low correlation my portfolio has to the S&P 500 or the MSCI World. If I can repeat my performance in recent years without tracking the big indices, I can probably also do it when the indices stop performing at those levels. And sooner or later, that will happen.

Absolute Returns and Overcoming Recency Bias

I posted a one-page summary of Seth Klarman’s book Margin of Safety yesterday. Klarman is an advocate of absolute performance. So, instead of using a benchmark, he focuses on the absolute returns of his portfolio.

He does so to avoid falling into the trap of short-term thinking to outperform the index every quarter and the consequence of more or less just tracking its positions (like so many funds do).

The high correlation with the index will make it virtually impossible to outperform it meaningfully or at all. For investors who joined the market after the financial crisis in 2008, this might sound like a fund manager's excuse to never admit he underperforms.

However, all of us who joined the markets in that period are recency-biased into thinking the stock market always performs at the astronomical levels we’ve seen in recent years. That’s not the case.

There have always been lost decades or years of low returns in the stock market's history. In those times, focusing on absolute returns makes sense. If the market returns 3%, you can outperform it with 4%, but that’s still not a good absolute return.

Conclusion

So, there is an argument for focusing on absolute returns, and in some (rare) cases, there might also be an argument for benchmarking against niche indices. However, in the vast majority of cases, I believe that you should use the major indices as benchmarks. Not necessarily on an annual basis, to avoid short-sightedness, but definitely over 3-5 year periods.

In recent months, I changed my strategy, and I’m now a lot more focused on micro caps. This takes more time to research because you really need to find the right ones (thus, fewer but higher quality research articles right now. I don’t want to spam mid-quality pitches just for the sake of it.)

But they also offer much higher returns. So, going forward, I raise my hurdle rate from 15% to 25% annual returns. With this goal in mind, comparisons to the market should become less important anyway since large caps can’t compete with these returns (at least over longer time horizons ;) ).

Yet, to conclude, I believe that every investor should use a benchmark that’s the realistic alternative for him to invest in if he wouldn’t invest actively himself. These should be the indices offering the best returns while being reasonably diversified. That can be the S&P 500 (although diversification is arguable) or an index investing in stocks globally.

That’s it for today! I hope you learned something new and/or at least found it interesting.

Best

Daniel