Creating The Customized ITA Index Benchmark For The Kenilworth And Other Portfolios

Constructing a customized benchmark to use as a performance standard is nearly as important as putting together a Strategic Asset Allocation (SAA) plan for a portfolio.  If one does not benchmark a portfolio how is it possible to know how well the portfolio is being managed?  To understand what is required to come up with a good benchmark, check this reference.  I also recommend reviewing the benchmark blogs by going over to the right-hand side bar and clicking on Categories.  Then select Benchmarks. 

I will use the Kenilworth to illustrate how the ITA Index customized benchmark is constructed for this particular portfolios.  Thirty percent (30%) of the portfolio is allocated to U.S. Equities.  This 30% is spread out over different cap sizes and investment styles.  The benchmark for all these different asset classes is the VTSMX index fund from Vanguard.  It is a total U.S. market index so it serves as the benchmark for 30% of the Kenilworth.  Twenty-five percent (25%) of the Kenilworth is devoted to international markets.  Part is allocated to developed markets and another piece is placed in emerging markets.  The benchmark for all international equities is the VGTSX global index fund.  We have now assigned 30% to VTSMX and another 25% to VGTSX.  That leaves 45% for alternative benchmarks.

The customized benchmark (ITA Index) is compromised slightly at this point.  For example, 19% is allocated to bonds and income.  I use BND as the benchmark for 20% of the portfolio as this includes the 19% allocated to bonds plus 1% held in cash.  The BND is not a perfect benchmark, but it is much better than simply lumping the entire portfolio under a commonly used benchmark such as the S&P 500.  The S&P 500 makes no sense as a benchmark for a portfolio holding international REITs, commodities, bonds, emerging markets, etc. 

We now have 75% of the portfolio benchmarked between three index vehicles.  How do we handle the remaining 25%? The last 25% of the portfolio is broken down as follows.  Ten percent (10%) is allocated to domestic REITs and 5% to international REITs.  Since I use VNQ to cover domestic REITs, VNQ becomes my benchmark.  RWX serves as the benchmark for the 5% allocated to international REITs.  The final 10% of the Kenilworth is divided equally between commodities (DBC) and international bonds (PCY).  PCY is actually an emerging markets sovereign debt ETF.  I use PCY as a proxy for the international bond allocation.  DBC and PCY are the final two pieces to putting together the ITA Index, the customized benchmark for the Kenilworth portfolio.

While the ITA Index is not a perfect customized benchmark, it goes a long way toward helping the portfolio money manager know how well the portfolio is performing when measured against this particular index.  As shown in an earlier post, the IRR value for the Kenilworth is almost exactly equal to the ITA Index.  This indicates the manager of the Kenilworth is keeping the portfolio in balance with respect to the Strategic Asset Allocation plan.  When the IRR of the portfolio gains ground on the IRR of the ITA Index, the improvement is due to making correct Tactical Asset Allocation (TAA) moves as called for by the ITA Risk Reduction (ITARR) model.  When the IRR of the portfolio falls below the IRR of the ITA Index, the money manager is not making correct TAA calls or the ITARR model is not working properly.

Every portfolio calls for a benchmark.  The ITA Index is an effort to measure portfolio performance against a fair standard.

ITARR Kenilworth Portfolio Update: 19 July 2012

As one of the five ITA Risk Reduction model portfolios, the Kenilworth is well worth your attention.  Although rather new and small in size, sixteen asset classes are used to fill out the capital allocation plan.  Cash contributions come in every month helping to rebalance the portfolio when necessary.  Due to the influx of cash each month, I am not overly concerned about Large-Cap Value and Large-Cap Blend showing up as above the target percentages.  Those two asset classes will come back into balance as more cash is added and invested in the other asset classes.

[Read more…]