To understand the importance of benchmarking, it is necessary to understand the concept of economic profit. Economic profit is found by subtracting opportunity costs from accounting profit. Imagine quitting your job and investing $200,000 to start a business. At the end of the first year your net business income is $250,000; you have earned $50,000 in accounting profit. If the job that you quit to start your business would have paid you $70,000 in that same year, you have incurred an economic loss of $20,000.
This same concept can be applied to evaluating the performance of an investment portfolio. In the context of financial markets, opportunity cost is the performance of a relevant benchmark. If your portfolio returned 18% net of fees last year, you achieved a seemingly attractive accounting profit of 18%. If the benchmark that your portfolio is evaluated against returned 38% in the same year, you have experienced a significant economic loss of 20%. Very simply, a positive economic profit occurs when a portfolio beats the benchmark index, and an economic loss occurs when the benchmark index beats the portfolio.
It is very easy for an investor to be blinded by positive accounting profits while enduring economic losses. This is particularly salient after a year like 2013 when many investors received positive returns reflective of the positive performance of markets. While an investor may be pleased with a 7% return on their Canadian equity portfolio, the S&P/TSX 60 was up over 13%. Assuming that the S&P/TSX 60 can be bought through an ETF for around .18%, there has been somewhere around 6% of return left on the table – a 6% economic loss.
This situation arises when a portfolio aims to beat its benchmark index. A portfolio that is trying to beat its benchmark index will hold a subset of the securities within the index that are predicted to perform better than the index itself. In a year like 2013 when the whole index is up, there is a good chance that the subset of the index held within the portfolio is also up. It is very important for investors to understand that even if their portfolio has been producing positive returns, if the benchmark is doing better than their portfolio, there is opportunity being lost.
Original post at pwlcapital.com