Jun 16, 2021 06:17 PM

Fisher: Broader Indexes Offer Better Stock Portfolio Benchmarks

Once you build a portfolio, use your benchmark to gauge your sector and industry tilts’ effectiveness. Photo: VCG
Once you build a portfolio, use your benchmark to gauge your sector and industry tilts’ effectiveness. Photo: VCG

How are you doing? How an investor’s portfolio is actually doing is often like the definition of beauty — determined in the eyes of the beholder. Even investors with eerily similar portfolios offer wildly different replies depending on how they define success. Some might measure performance against an arbitrary figure they wish to reach. Others might aim to best their friends’ or relatives’ returns.

Still others simply see any gain as good and any decline as bad. But in my 49 year investment career I’ve come to view the best way is benchmarking — measuring your portfolio’s return against an index representative of, in your case, China’s vast, vibrant economy — or that of the whole world for me (and maybe you). Doing so provides both a performance measuring stick and, crucially, a blueprint for building a diversified portfolio. Here is how you can do it like a professional.

Today, indexes abound. But those tracking the same market can diverge drastically in composition — and performance. Some, like the CSI 300, focus only on the largest A-shares. Others key on smaller firms, while still others include a mix of sizes. Many focus exclusively on particular “styles” of stocks, such as growth or value.

Even benchmarks including the same exact stocks can diverge sharply, based on how they are calculated. In “cap-weighted” indexes, an individual stock’s impact depends on its market capitalization—the total value of all its shares. The higher the firm’s market value, the more pull it has on the index’s performance. “Price-weighted” indexes — like the oldest gauge, America’s famous, 125-year-old Dow Jones Industrial Average — give higher-priced stocks more actual influence (and amazingly, after all this time, few investors seem to understand or accept that). That is a fatal flaw, given share price is often unrelated to a company’s market might. Hence, most investors should benchmark their portfolio against a broad, cap-weighted index — one whose sector, industry and style composition reflects the full range of opportunities their market offers. This provides only a starting point for determining the makeup of your own portfolio.

How does China’s often-referenced CSI 300 stack up? While it is cap-weighted and fairly broad, its omission of big tech stocks trading off the mainland make it less desirable than others — not as reflective of how China’s economy looks now. These firms — including the huge online retailers you know so well — may spark controversy, but big tech is vital to today’s China. Yet tech composes only 10.6% of the CSI’s market cap, with no tech firms among its 10 biggest holdings. Instead, value-focused sectors dominate. Financials and consumer staples account for 29.2% and 16.7%, respectively, of the index. For comparison, these dwarf the world’s 14.7% and 7.0%. Industrials — another value-tilted area — slightly outweighs tech, too, at 11.2%. Investors benchmarking to the CSI may be unintentionally take on a hefty value tilt while underweighting the “new” Chinese economy.

To take advantage of China’s full economic breadth, employ a more comprehensive benchmark — like MSCI’s China Index. While the CSI includes only the 300 largest A-shares, the MSCI China features 709 constituents. Many are Chinese firms trading in Hong Kong — available through Stock Connect programs. Don’t let the index’s 6% tech sector weighting fool you. Loads of tech-like firms — including those big internet retailers — reside in its consumer discretionary and communications services sectors. Including them, tech is closer to 45% of the index’s market cap — a lot, given the world’s 30% weighting! But China’s emerging tech prowess merits the big tilt.

MSCI’s China Index right-sizes other areas, too: financials are 14% of market cap and consumer staples 5%. Both nearly match the world’s overall weights.

Does this mean the MSCI China will outperform the CSI 300 over the long haul? Nope. Over the very long term, all cap-weighted benchmarks’ returns should cluster in a narrow range. Why? Because simple supply and demand drives equity prices. The more people start thinking one equity category is superior, the more demand grows for those firms’ shares. Investment bankers ramp up share supply to meet demand, but almost always they eventually overshoot. As supply surpasses demand, once-hot sectors or industries either plunge sharply or turn tepid for years — and the indexes favoring them follow. This supply expansion and contraction bars any sector — or index — from permanent superiority.

Hence, picking the right benchmark is less about finding a path to bigger returns and more about finding a smoother, less wild and wooly, path to a similar end point. Narrower benchmarks lead to bigger volatility — the kind that often psychologically shake investors out of stocks at the wrong time. The MSCI’s breadth — both in sheer number of constituents and its inclusion of more pieces of modern China’s economy — should make for a smoother ride over time.

That doesn’t mean you need to own anything close to all 709 of the index’s stocks. But its sector and industry weightings give you a blueprint for building your own portfolio. Make the big decision first: Do you expect a bear market? If so, dramatically reducing equity exposure may make sense.

But if you expect a continued bull market, as I do now, owning stocks in sectoral proportions similar to your benchmark makes sense. Don’t mirror it exactly. If you are optimistic on a sector, own more of it than the benchmark. Pessimistic? Own less. But don’t stray too far, though — that introduces big risk. Always remember: You (and I) could be wrong! The further you shift from your benchmark, the more you risk getting clobbered — and missing out on stocks’ stellar long-term returns. I always own some stocks in sectors I’m not keen on for diversification’s sake.

Presently, despite their stumbles since February, I think growth stocks like China’s big tech and tech-like names are poised to refuel market gains. That means making sure your allocation to these firms is near the MSCI China’s, perhaps even slightly higher. Also consider overweighting other growth areas, like health care stocks. They are 8% of the MSCI China and offer ample opportunity.

I’m less optimistic on value-heavy categories like financials, energy and industrials. They do best when economic growth is set to roar, but the fastest part of China’s post-Covid rebound is already past. Pre-pandemic norms are resuming — ahead of the world, due to China’s effective Covid response. Further, China’s financial liberalizations — hugely and broadly positive long-term features — create short-term headwinds for banks. Don’t ditch these areas altogether, though. Remember: I could be wrong! So could you. Instead, simply carry somewhat less than your benchmark does.

Once you build a portfolio, use your benchmark to gauge your sector and industry tilts’ effectiveness. If doing well, in bull markets, you should track similarly to your benchmark’s return — but a nice notch ahead. You won’t beat it every quarter or year. No one can do that. But over the long term, savvy, subtle sector weights actively shifted as your expectations of conditions shift ahead of others do — can help you top your benchmark —without taking on unnecessary risk.

Ken Fisher is the founder and executive chairman of Fisher Investments.

The views and opinions expressed in this opinion section are those of the authors and do not necessarily reflect the editorial positions of Caixin Media.

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