What is the appropriate benchmark for a TAA portfolio? This is a subtle but I think often overlooked aspect when measuring the performance of a TAA strategy or portfolio. The classic choice, just like in buy and hold, is the 60/40 US stock, US bond portfolio. The are other choices and in this post I’ll discuss three choices and conclude with why for most investors the classic choice is probably the best one.
The most commonly used benchmark for most of the investment industry, buy and hold or whatever type of investor, is the 60/40 portfolio. That portfolio is composed most often of 60% US large cap stocks, represented by the SP500, and 40% US bonds, most often US intermediate term treasuries. There is constant talk about how that benchmark is not appropriate because it is so US centric but that is the reality, just like in the news the Dow Jones is the most often quoted stock index, not the SP500, even in modern times. And to add insult to injury the gains and losses are still quoted in points and not percentages. Old habits die hard. So, were going to use that benchmark for sure.
A more ‘appropriate’ benchmark should be a Global 40/40 portfolio. US markets while still representing the majority of global asset markets, it is not the only game in town. A better benchmark would be a 60/40 portfolio that extends the equity and bond piece to include global stocks and global bonds. I’m going to leave out commodities and gold because for the most part they do not enter the discussion most of the time when talking about benchmarking a portfolio, rightly or wrongly.
Lastly, the largest equity market in the world, represented by the SP500, is the most common benchmark used for aggressive strategies. At least in terms of returns. Now that we have the three benchmarks to consider lets compare them side by side. The tool I is a portfolio allocation calculator I offer to my subscribers. In the table below, Portfolio 1 is the SPY (SP500), Portfolio 2 is the 60/40 US portfolio benchmark, and the benchmark is the Global 60/40 portfolio. Data is from 1998 through April of 2024.
As you can see from the table these portfolios results are quite different. As you would expect the SP500 has the highest returns but also the highest drawdowns. As for the 60/40 portfolios, the outcomes are also quite different. The US centric 60/40 has outperformed the Global 60/40 portfolio by a large margin. In terms of risk adjusted returns, it is almost double the performance of the global portfolio. And if we looked at more recent time periods the difference is even more pronounced. Obviously, this would have an impact on how you view your own portfolio choices.
Let’s use a concrete example to see how the choice of benchmark may influence you. One of the earliest TAA strategies available to investors was Meb Faber’s AGG3 strategy. You can read all about it in this detailed post from Allocate Smartly. Also, Meb’s original TAA paper, published in 2007, is available here. I also track this strategy and some of it’s variants on my site for free. It is one of the handful of TAA strategies for which we have the longest out of sample performance. Below is the performance of the strategy vs the two diversified benchmarks, US 60/40 and Global 6040 (shown in Portfolio 2), since 1998.
Fantastic long term performance since 1998 and with half the drawdowns of 60/40. Based on backtested performance it would haven been a great choice for a TAA strategy. But let’s look at the out of sample performance vs the two 60/40 benchmarks which I highlighted in the green box. From 2008 to 2023, AGG3 performance was significantly lower than you would have expected at the time you invested in it in 2008. That could be ok but it underperformed the US based 60/40 portfolio. However, it handily outperformed the Global 60/40 portfolio. How would you judge AGG3’s performance over this period? Would you have abandoned the strategy? Your choice of benchmarks would probably influence your judgement. Objectively, for this strategy I think the appropriate benchmark was and is the global 60/40 portfolio but with all our behavioral biases and the financial media you’d be hard pressed to feel very good about the performance of the portfolio since 2008.
So, what is the right answer? I think the best answer is to choose a benchmark that would most likely reflect the portfolio that you would be using if you were not doing TAA, i.e the buy and hold portfolio would you be using. For most investors, survey data shows that that portfolio would most likely resemble the US centric 60/40 portfolio. It is also what most of the investment industry uses for it’s benchmark. For non US investors, this is probably different and the Global 60/40 may represent better what they would be doing. Whatever benchmark you use, just keep in mind when doing your strategy comparisons that your perspective may change when compared to a different benchmark.