How to Think about Benchmarks
Plus Q2 Market Report

It’s our nature to compare our performance to others. Clothes, cars, homes, vacations, athletic skill, personal wealth, even our kids—it’s all part of a complex mental calculation that tells us how we stack up. But is there any such thing as a reliable benchmark? In life, certainly not. In investing, the answer also is “no,” as evidenced by substantial tracking error in classic benchmark indices. What’s an investor to do? We’ll share our advice after a review of Q2 markets.

Second Quarter 2018 Index Returns

(Courtesy of DFA)

World Asset Classes

Looking at broad market indices, the US outperformed non-US developed and emerging markets during the second quarter.  Small caps outperformed large caps in the US but underperformed in both non-US developed and emerging markets. The value effect was negative in the US as well as markets outside the US.

US Stocks

The US equity market posted a positive return, outperforming both non-US developed and emerging markets in the second quarter. Large cap value stocks underperformed large cap growth stocks in the US; however, small cap value stocks outperformed small cap growth. There was a positive size premium, as small cap stocks generally outperformed large cap stocks in the US.

International Developed Stocks

In US dollar terms, developed markets outside the US underperformed the US but outperformed emerging markets during the second quarter. Value underperformed growth in non-US developed markets across large and small cap stocks. Small caps underperformed large caps in non-US developed markets. 

Emerging Markets Stocks

In US dollar terms, emerging markets posted negative returns in the second quarter, underperforming developed markets including the US. The value effect was negative in large caps; however, value and growth stocks had similar performance among small cap stocks within emerging markets. Small caps underperformed large caps in emerging markets. 

Real Estate Investment Trusts (REITs)

US real estate investment trusts outperformed non-US REITs in US dollar terms.

Commodities

The Bloomberg Commodity Index Total Return gained 0.40% during the second quarter. The energy complex led performance with Brent oil returning 16.18% and WTI crude oil 12.70%. Grains was the worst-performing complex; soybeans declined 18.40%, and soybean meal lost 15.85%.

Fixed Income

Interest rates increased in the US during the second quarter. The yield on the 5-year Treasury note rose 17 basis points (bps), ending at 2.73%. The yield on the 10-year T-note rose 11 bps to 2.85%. The 30-year Treasury bond yield climbed 1 bps to 2.98%.

The 1-month Treasury bill yield rose 14 bps to 1.77%, while the 1-year Treasury bill yield increased 24 bps to 2.33%. The 2-year Treasury note yield finished at 2.52% after increasing 25 bps.

In terms of total return, short-term corporate bonds gained 0.29%, while intermediate-term corporate bonds declined 0.10%.

Short-term municipal bonds added 0.66%, while intermediate-term munis returned 0.81%. Revenue bonds performed in-line with general obligation bonds, returning 0.90% and 0.87%, respectively.

 Impact of Diversification

These portfolios illustrate the performance of different global stock/bond mixes and highlight the benefits of diversification. Mixes with larger allocations to stocks are considered riskier but have higher expected returns over time. Global Stocks represented by MSCI All Country World Index (gross div.) and Treasury Bills represented by US One-Month Treasury Bills.

Feature article

Outsmarting Tracking Error

Benchmark indices are a commonly used measure of investment performance. Active investors use them to rank star investment managers (last year’s stars, anyway). Passive investors use them to track asset class performance over months, years and decades. Cardiff Park reports on a broad set of benchmark indices each month to track the relative performance of different parts of the capital markets.

With the rising popularity of index investing, the use of benchmark indices has shifted, in some cases becoming the foundational strategy for investors seeking to precisely replicate market performance. But when the indices become the strategy itself, it pays to be aware of potential risks and costs.  

Over the last few decades, benchmark indices have exploded in number. The Index Industry Association (IIA) reports that there are now nearly 3.3 million stock market indices around the world, or 70 indices for each stock listing. Most investors are familiar with a small subset of indices that track specific asset classes. For Large Cap Value, for instance, one could choose to track indices from Dow Jones, S&P, MSCI and Russell, among others. Each index defines the asset class it’s tracking slightly differently and adheres to a different rebalancing schedule. But if a set of indices all track the same thing, how different can results be? 

Very different, it turns out. In fact, the range may surprise you. Between January 1999 and June 2012, a study by DFA demonstrated that the S&P 500 Value Index had a rolling one-year swing ranging from +10.21% to -3.73% as measured against the Russell 1000 Value Index. The difference in small cap value indices was even greater, with MSCI USA Small Cap Value ranging from +17.13% to -16.04% compared to the Russell 2000 Value Index.

If these results were persistent, investors would gravitate to the index that always performed the best. But over time, the DFA study showed that the high and low performers targeting similar asset classes tended to switch places. Indices, after all, are not created to forecast, time or beat the markets. Their performance differences are random. As a result, DFA concluded, “the selection of a specific index as the benchmark to track is likely to be somewhat subjective.” And because every index will have tracking error relative to others, “trying to achieve perfect replication should not be an objective due to the high costs.”

The Price of Pursuing Perfection

Let’s take a closer look at those high costs. When fund managers seek to match a chosen benchmark, costs are incurred as a result of reconstitution (rebalancing that occurs once or twice a year), style drift and concentration risk.

Reconstitution takes a hit on investors when index funds buy and sell during a narrow window of time, and nearly always when similar funds are buying and selling, which drives prices up or down. The index fund manager’s job is to match the returns of the index, not to generate the highest returns. This runs counter to what most investors want for their money. 

Style drift costs investors in another way. Between periods of reconstitution, securities can rise or fall to the point where they no longer reflect the expected return of their asset class. For instance, a value stock may rise in price to the point where it no longer represents “value,” or a small-cap stock could rise to become a mid-cap. These stocks remain in the portfolio until the next rebalancing period, effectively lowering the index tracker’s expected rate of return.

Concentration risk is another factor contributing to cost. The early 2000s offered a great example of how this happens, as the price of tech stocks climbed until these stocks represented over 50% of the Russell 1000 Growth Index. Index tracking fund managers were hamstrung. Investors were forced into the over-exposure.

Again, all this is in service of attempting to match returns of a chosen benchmark. Are the costs worth it? Is there a better, more efficient way to achieve the returns of a targeted asset class?

Yes, and it is the DFA approach. DFA maintains appropriate asset class exposure by trading throughout the year rather than adhering to rigid, predefined benchmarks. This protects expected returns, creates flexibility to respond to market opportunities, and enables better cost management. It’s why DFA funds are generally the preferred building blocks for equity allocations in Cardiff Park’s portfolios.

I’ve heard DFA compared to the Google Maps of index investing. It’s an apt analogy. DFA uses real-time market information to dynamically map the way. And when the traffic gets congested, during expected rebalancing periods for instance, DFA can alter the route and follow the path of least resistance to capture expected return. It’s a smarter and more thoughtful alternative to trying to precisely match the indices.

Why Strategy Matters Now

I don’t want to close our Q2 report without circling back to the big picture of strategy. When investors lack an overarching financial strategy, they’re susceptible to anxiety, hearsay, and impulsive decision making. That’s not a good way to manage money.

In a recent commentary, DFA co-founder David Booth offered a reminder that while we can’t control the events that happen every day, we can control our response. And controlling our responses can have a tremendous effect on outcomes. After Brexit, for example, markets tumbled and many investors cashed out at a nasty loss. Now trade wars are heating up, and the daily news and crisis du jour are causing investor whiplash. How will you respond?   

My advice is to stick to strategy and the financial plan we’ve designed together. Don’t respond at all. Instead, maintain a long-term outlook, keep costs as low as possible, trade infrequently and stay diversified. And please don’t be concerned about tracking error. The important issue is to know where you’re going and how likely you are to arrive at your destination. Investing is a long-term endeavor.

Do you have questions or concerns? Call me, I am here to help.

John Gorlow

President

Cardiff Park Advisors
888.332.2238 Toll Free
760.635.7526 Direct
760.271.6311 Cell
760.284.5550 Fax
jgorlow@cardiffpark.com