How's your global portfolio?
Wall Street loves to benchmark against the S&P 500 index. Here's a better approach.
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| Ask Money Magazine's undercover financial planner a question. Send e-mails to: themole@moneymail.com |
NEW YORK (Money) -- Question: I agree that it is misleading for planners to show clients results of their global portfolio compared with the raw S&P 500, stripped of dividends. Does the Mole have a suggested alternative for the best way to show clients the results of their global portfolio?
The Mole's Answer: I love this question that came to me from a CFP via a letter to the editor in the June issue of the Journal of Financial Planning. Let me expand on why the S&P 500 index is great for us planners but very misleading and costly for consumers. Then I'll give that alternative benchmark.
Most planners, including me, put our clients in a global portfolio of U.S. stocks, international stocks, and bonds. I think this is the right thing to do, since we live in a global economy.
Now for some reason, possibly Wall Street's marketing muscle, we view the S&P 500 index as the stock market. There are two reasons why this index is the wrong benchmark to compare your portfolio to.
The S&P 500 companies are essentially the largest U.S.-based companies. They happen to represent roughly 80% of the market capitalization of the U.S. stock market. But, the U.S. stock market is now only about 40% of the total global stock market capitalization. Thus, the S&P 500 companies are only about 32% (80% of 40%) of the global stock market value.
These S&P 500 companies also happen to be the worst performing of the global stock market over the past ten years. So comparing the total global market to the worst performing 32% of the market is a really easy benchmark to beat.
Any index, including the S&P 500 index, includes only the gain from capital appreciation. An index excludes the part of the return from dividends. For example, in 2007, the S&P 500 index increased 3.5% while the total return from S&P 500 stocks was 5.5%. The difference being the 2% yield that came from the dividends that were distributed by these 500 companies.
I'm a believer in keeping things simple so I use only three benchmarks to compare a portfolio's return - a total U.S. stock index fund, a total international stock index fund and a total bond index fund. I use the retail funds themselves, rather than a theoretical index plus dividends, because all funds have some costs and I want a reality-based comparison.
I use the following three funds:
- Vanguard Total U.S. Stock Index VTSMX
- Vanguard Total International Stock Index VGTSX
- Vanguard Total Bond Index VBMFX
I then weight each of these returns according to the actual weighting in the portfolio I'm benchmarking. For example, a portfolio that is 60% U.S. stock, 30% international stock, and 10% fixed income should have returned 8.6% in 2007 as shown in the illustration. The same allocation of index funds would have returned 17.7% in 2006.
If, for example, this client's portfolio earned only 6.6% in 2007, and 15.7% in 2006, I would show that they underperformed by 2.0% each year. The client's previous adviser, however, compared their performance to the S&P 500 index returning only 3.5% in 2007, and 13.6% in 2006. Thus the adviser created the illusion of beating the market when, in actuality, they significantly underperformed.
When I do this benchmark for clients, many get it immediately and are willing to move toward a portfolio using vehicles like the ones we used in this benchmark. On the other hand, there are those who actually become upset, as I suspect they place great value on maintaining the illusion of beating the market. In this instance, I'll hear some variation of the response "Well, the S&P 500 index is the accepted definition of the market."
My advice: Don't take your adviser's word for it that you are beating the market. Give the chart to your adviser and ask him to update it using your allocation of U.S. stocks, international stocks, and fixed income. Then compare your returns to this benchmark and get ready for some back peddling. If you don't have an adviser, fill it out yourself. Just one warning - you may not like the results.
The Mole is a certified financial planner and certified public accountant who - in the interest of fairness - thinks you should know what goes on behind the scenes in financial planning. Want to make contact? E-mail themole@moneymail.com. 
