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Benchmarking Your Portofolio's Performance
by Benjamin B. Taylor 
August 8, 2005 
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Benchmark Your Portfolio Against the Appropriate Index


Benchmarking your portfolio's performance against against a stock market index is a vital exercise. With the proliferation of passively managed index mutual funds at low costs, it makes sense to know whether or not you or your investment manager is adding value by picking individual stocks or actively managed mutual funds. If you find that you or he is not adding value then it makes little sense to move beyond investing in index mutual funds.


When benchmarking a portfolio investors have multiple indexes from which they can use.  Although all measure the movement of the stock market or specific portions of the stock market, each does so in a slightly different way. Indexes are usually created by research organizations such as Standard & Poor’s, Dow Jones, Wilshire & Associates, MSCI, Lehman Brothers, Russell & Co. and many more.  The major indexes created by these companies include:


  • The Dow Jones Industrial Average (DJIA) created by the Dow Jones Company

  • The S&P 500 created by Standard and Poor’s

  • The Russell 2000 created by Frank Russell Company

  • The Wilshire 5000 created by Wilshire Associates


What individuals may not realize is that out performance or under performance of any index may have little to do with stock selection and more to do with the index the investor chooses to benchmark his performance against.


Dow Jones Industrial Average (DJIA)


The DJIA is the oldest continuing U.S. stock market index. It is comprised of 30 large company stocks that are meant to reflect most sectors of the U.S. economy. The DJIA is the best-known market indicator in the world, partly because it was the first of its kind.


The "average" is in the title because the index's performance was originally computed by adding up stock prices and dividing by the number of stocks. The DJIA is a price-weighted index calculated daily based on the price of each company without any regard to the relative size of each component. In other words if McDonald’s is trading at $75 and Microsoft is trading at $25, McDonald’s would hold more weight in the index’s average even though Microsoft is a much larger company.


There in lies the major flaw of the DJIA. It is not really representative of how most stock market investments are fairing. If more money is invested in Microsoft than McDonald’s it seems axiomatic that Microsoft should make up more of any particular index. Another flaw is the DJIA’s size of just 30 mega-sized companies. Because the index is not diverse and it only consists of extremely large companies, it may not accurately reflect the performance of vast swaths of the U.S. or global marketplace.


Although the DJIA is the most quoted and best known of all the indexes, it is probably the least relevant as a benchmark.


S&P 500


The Standard & Poor's 500 Index is the preferred benchmark for most investment professionals as it has the triple benefit of representing a substantial portion of the U.S. stock market (about 75%), being market weighted (as opposed to price weighted like the DJIA) and it is well known.


The S&P 500 consists of a basket of 500 companies from a diverse range of industries. The companies that comprise the index are not the simply the largest 500 U.S.-based companies, but the companies chosen by the S&P Index Committee for market size, liquidity, and sector representation. The S&P 500 is a market-capitalization weighted index. In other words Microsoft would make up more the index than McDonald’s since its market capitalization is much larger.


There are two major drawbacks of using the S&P 500 as an index. One drawback is is that it has significant liquidity requirements for its components, so some large, thinly traded companies are ineligible for inclusion. Warren Buffett’s company Berkshire Hathaway is not included in the index for this very reason even though it is one of the largest companies in the world. Another drawback is that since the index gives more weight to larger companies, it tends to reflect the price movement of a just a few large company stocks. It does not accurately measure smaller companies.


Russell 2000


The Russell 2000 is the best-known of a series of market-capitalization weighted indices published by the Frank Russell Company. The index measures the performance of the smallest 2,000 companies in the Russell 3000 Index. The Russell 3000 is made up of the 3,000 largest U.S. companies in terms of market capitalization and represents 98% of the stock market. Unlike the S&P 500, it does not cherry pick the companies that make up the index by requiring substantial liquidity or that the index represent certain sectors of the economy. It is a truly passive index.


The Russell 2000 is most appropriate for benchmarking the performance of U.S. small capitalization stocks. But these aren't the smallest of the small. The Russell 2000 makes up only about 7% of the total market capitalization of the stock market. The two drawbacks of the index is that it does not measure the performance of large-cap stocks and micro-cap stocks. In other words, stocks that are among the largest 1000 and those that are smaller than the 3000 companies in the Russell 3000, do not get measured by this index.


Wilshire 5000


The Wilshire 5000, a market-capitalization weighted index, measures all the stocks traded on the major U.S. exchanges as long as they are U.S. headquartered. It only excludes stocks traded via the Bulletin Board system where most penny stocks of extremely small companies are listed. Unlike the other indexes that carry the number of stocks it holds in its name, the Wilshire 5000 actually has close to 7,000 companies. The number included in the index fluctuates as companies are listed and de-listed from the major exchanges. Although this index is less well known than the others, it is in fact the largest index by market value and most comprehensive of all the major U.S. indexes.


The major drawback of the index is that the 500 largest companies comprise more than 70% of the index's value, so total performance is weighted toward the top few (relatively speaking) companies.


All that said, the Wilshire 5000 is probably the best measure of U.S. stock market performance available.


Certainly the indexes mentioned here do not comprise the entire landscape of all indexes available for benchmarking. In addition to these broad U.S. market indexes, there are hundreds of indexes measuring various market sectors in the U.S. and around the world.




Measuring index performance or benchmarking a portfolio does not have to be an extremely difficult task.  When choosing an index to invest in or benchmark a portfolio against make sure the structure of the index is applicable to the portfolio you are trying to build.  If you are investing in primarily well known large company stocks, perhaps the S&P 500 is an appropriate benchmark. If you are investing in stocks regardless of size, perhaps the Wilshire 5000 is better.


An important point to consider is making certain the benchmark you or your advisor uses is an apples to apples comparison. Many investment professionals are guilty of making apples to oranges comparisons all the time – many times for their own benefit. A manager may be primarily invested in small cap stocks when small caps in general are performing well and compare his performance to a large cap index.  Typically investment professionals who have a large cap mandate will delve off into smaller equities in hopes of increasing portfolio returns and beating their stated index.  Thus, in reality the comparison to a large cap index such as the S&P 500 is not really relevant and gives you little information into whether not the manager is adding value to your investment program.




© Brick Financial Management, LLC, PhatKnot Media, LLC, Benjamin B. Taylor, all rights reserved. No material that appears here can be reproduce without express written permission. However, permission is hereby granted to electronically link to, forward or quote passages as long as source is attributed to "Benjamin B. Taylor, President of Brick Financial Management,"

Although we believe the information and data in this report were obtained from sources considered reliable and correct, we cannot guarantee their accuracy or completeness. Neither this commentary, nor any opinions expressed herein, should be construed as an offer to sell or a solicitation of an offer to acquire any securities or other investments mentioned herein.
This information should not to be construed as investment advice. Persons associated with this firm may own or have an interest in securities or investments mentioned in this presentation. Their positions may change from time to time and they may buy or sell such securities or investments. Past performance is never a guarantee of future performance.

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