Money Management and Portfolio Performance
By Jeffrey S. Coons; PhD, CFA
By Christopher J. Cummings; CFA, CFP
Evaluating portfolio performance is a vital and often contentious topic in monitoring progress towards a physician's investment goals.
Introduction
A typical portfolio's objective may be to preserve the purchasing power of its 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 for the doctor; performance numbers need to be evaluated based on an understanding of the market environment over the period being measured.
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 physician investor and/or 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 U.S. 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:
· Lehman Brothers Government Credit Index - an index of investment grade domestic bonds excluding mortgages.
· Lehman Brothers Aggregate Index - the LBGCI plus investment grade mortgages.
· Solomon Brothers Bond Index - similar in construction to the LBAI.
· 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.
Assessment
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.
Conclusion
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.
Fortunately, capitalization-bias does not typically affect long-term performance comparisons, but 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. Therefore, a physician 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.
How do you evaluate your portfolio?
Do you evaluate it on a risk-adjusted basis?
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