The answer to the latter is yes and no. Those of us who believe that only the portfolio matters, are interested in what markets are doing longer term, but treat shorter term volatility as simply noise. In that light, five year compound numbers have value, shorter term numbers less so.

We believe there is real danger in making investment decisions on the basis of short term noise. That usually results in the premature exit from what is likely a solid long term strategy. On the other hand, using short term information – like the performance of the markets in a given year - to provide insight as to whether or not we are on the right track does have value. The trick is to balance value against the temptation to change.

Investors follow market indexes because they realize that the market itself has a systematic pull on a portfolio. If you own common shares, it is likely that as much as half the daily returns on those shares is affected by how the markets are performing. If you have a well-diversified portfolio - as we have been preaching - most of the returns, will be affected by the systematic pull of a proper market index.

Second, market indexes are used by some investors to gauge the momentum and sentiment of the market. This approach is called technical analysis, and indexes factor heavily in its use.

We believe one of the key values of an index is that it can be used as a gauge to measure performance against specific objectives. Properly structured indexes can provide that gauge and as such, serve as a benchmark or bogey for the performance of your own investment portfolio. In other words, you can use the benchmark to see whether your portfolio management skills are as good as you think they are - and, more to the point, whether your investment Advisors’ skills are as advertised.

Why A Portfolio Benchmark?

Last year your portfolio returned 10%. Was that good or bad? Well, if you are comparing the performance of your portfolio to GIC’s earning 3%, then the return was pretty good. If you are comparing your return to the S&P / TSX 60 composite index (representing a basket of Canadian stocks) which returned as we said, 24%, then the numbers don’t look so good.

The problem of course, is that most investors don’t have 100% of their portfolio in GICs, nor do they have 100% of their portfolio in Canadian stocks. Most have a combination of investments, somehow divided between cash, income and growth. We think of cash in terms of treasury bills. Bonds or bond funds are generally used to represent income assets. And stocks or equity mutual funds represent growth assets.

If we accept the position that most investors have a diversified portfolio, then we have to also accept that a 10% return tells us nothing about value. It’s like having a son who is seven feet tall. Is that good or bad? It’s good if he wants to play professional basketball. No so good if he wants to buy ready to wear clothes.

Only by comparing a diversified portfolio against a passive portfolio benchmark, can you make informed judgments about how well your portfolio did. If a properly constructed passive benchmark returned 7%, and you returned 10%, then your portfolio did very well indeed.

The passive nature of the benchmark is important in this discussion, because if you have an actively managed portfolio, you want to know if the active management added value. By comparing to a passive index you can make that judgment. The difference between the performance of your portfolio and a passive index may reflect the value added or left on the table by active management. Again, if your portfolio earned 10% while a suitable or appropriate benchmark earned 7%, then you would surmise that your active selection added 3% in value (although longer term analysis is still important because the one year the 3% difference could have been attributable to chance!).

The Rationale for Portfolio Benchmarks

We have long thought that Advisors should provide clients with appropriate benchmarks. For two very fundamental reasons. The first is a practical one; if an Advisor does not provide a benchmark to measure performance, the client will. And that’s probably not a good idea, because the client may end up choosing a totally inappropriate benchmark.

A benchmark has to have certain properties before it is useful, and it’s unlikely the client will consider all of these factors when picking one.

The second reason is that a benchmark forces both the Advisor and the client to focus on the portfolio as a whole. If you do not focus the discussion on the portfolio, the focus will move to the individual securities in the portfolio and more specifically to the securities that have lost value. Also not a good idea.

Remember that the key element in portfolio construction is to build something that reduces risk and enhances return. Risk reduction can only come through diversification, and diversification is only valid if the securities in the portfolio have low correlations with each other. Put another way, in a properly constructed portfolio, there should always be something that is not doing well, and if that becomes the focus, it serves no useful purpose in a long term investment plan.

If the client becomes fixated on the individual securities in the portfolio, we guarantee two things will happen: the first fifteen minutes in any meeting between client and Advisor will be spent talking about the securities that went up in value, and next hour will be spent discussing the securities that went down in value. Nothing of value will get done, and both sides end the meeting in frustration.

So in the end the only valuable benchmark is a portfolio benchmark. And the only valuable portfolio benchmark is one that is passive and focuses exclusively on your objectives.

The FPX indexes were designed as portfolio benchmarks, and the reason we have three indexes, is that each represents a type of investor; conservative, balanced or growth.