Benchmarking Performance

“How are your investments doing?” If you don’t know the answer to that question, don’t feel so bad. Most investors don’t know the answer either.

That said, it’s a logical question and one that should have an easy answer. After all, there is an abundance of financial companies touting numerous products and services as well as scores of investment advisors representing individual investors. The technology also exists to provide results with great speed and accuracy. Therefore, what makes it so difficult to know how well your investments are performing?

I think that self-directed investors lack the experience and knowledge to apply some of the tools that are currently available. For instance, Fidelity now reports rates of return for accounts. The problem lies in trying to interpret the data. A customer can see the rate-of-return on a particular account, but without a basis for comparison – it’s really just meaningless information.

You would think that people who delegate responsibility to a money manager would know exactly how their portfolio is doing, but they rarely do. When you pay someone to manage your portfolio, you should know whether or not they are doing a good job. If you do decide to ask the manager, be careful to view any response with some skepticism. Some will respond to “how am I doing?” by side-stepping the question much like a skilled politician. More likely, you will get a vague answer like “your account value is up compared to last year.” Of course this is meaningless, if the stock market had a good year and accounts are expected to be higher.

Some asset managers will show you reports that compare your account performance to the S&P 500 index for a selective time period. What does this really tell you? Most portfolios have much less than half of the assets in S&P 500 stocks. A portfolio should be diversified into small and mid-size company stocks, international stocks, several types of bonds, and possibly other asset classes. Comparing performance to the S&P 500 is pointless unless 100% of the account is invested in large U.S. companies. If your advisor has you invested entirely in stocks, you’ve got much bigger problems to worry about!

Whenever a benchmark is used, an investor should be wary, because almost any account can be made to look good by choosing a favorable time period or benchmark. For instance, a savvy investment manager could use the S&P 500 index to make a conservative portfolio look especially attractive over the past ten years because stocks – despite some periods of strong performance – have not done well during that time. Portfolios with a healthy mix of bonds over the past ten years will look very good by comparison especially with the downward trend in interest rates. Conversely, a diversified portfolio might pale by comparison against an all stock index in a shorter time period like the last three years, as the stock market has nearly doubled since the low point in 2009.

Any time period will have winning and losing asset classes and market segments. For an investor to really know how well they are doing, they must use a relevant yardstick. The benchmark should contain an index measure for each type of asset in which the portfolio is actually invested. That is, a portfolio containing real-estate investment trusts (REITS) should have the REIT index as part of the performance criteria. The benchmark should also be customized to the individual in terms of the dollar amount of each asset class to match the investor’s allocation target. For instance, an investor with an objective to have 40% in bonds should weight the benchmark 40% with a relevant bond index.

Unfortunately, a weighted-average index benchmark that is customized to the individual investor is about as rare as a Kardashian shopping at a Wal-Mart store. If fact in all of my years in the business, I think I’ve only seen one asset manager employ an appropriate methodology to measure results.

So if a customized weighted-average index is the only logical approach, why don’t more money managers use an appropriate benchmark to report client performance? The answer is both simple and disturbing. They don’t want you to know the true performance.

To add perspective, I had a new client recently who had invested $500,000 with a money manager about five years ago. The account had grown to $520,000. Smartly, the new client realized that since he had paid about $5,000 per year in fees to the advisor (1% per year) that after five years the advisor had made more money than he did! And the advisor had not taken any of the risk! You can bet that this particular manager did not want to be measured by an objective standard.

Most managers don’t want to be held accountable. They know – or at least they should know – that a portfolio of index funds designed with a similar risk profile will most likely out-perform the investments that the advisor will use, due to a decided cost advantage. With the advisor’s fee layered on top, it will only make the managed account’s performance look that much worse.

Please note that this does not mean that professional advisors are not knowledgeable or don’t provide some added value. The problem is that any value added from the function of money management is not worth the typical 1% fee (some have much higher fees). The most value provided by a professional advisor derives from the client risk assessment and the initial asset allocation. These tasks should take just a couple of hours to perform. After that, the main benefit from working with a professional advisor is to help you stick with “the plan,” to rebalance the investor’s accounts when they get out of line, and to address any other planning issues that arise. These are important activities, but they don’t require full-time money management.

Independent research shows that market-timing, tactical allocation, and various other active strategies under-perform an index-based strategy. The extreme low cost is what gives a market-matching index strategy a clear advantage over active management. In addition, a lesser known benefit is that you no longer have to monitor investment performance or worry about bad management. By definition, you can be certain that the index funds will track closely to the associated indexes. As long as you are comfortable that the asset allocation or risk profile is consistent with your needs, you don’t need to benchmark performance because you are in effect investing in the benchmark.

If you choose to self-manage your investments with an active strategy or delegate to a full-time money manager, you should make sure that the portfolio is reported and analyzed against a relevant and customized benchmark. This is the only way to truly know how well the portfolio is doing. If you like the idea of guaranteed superior results and not having to worry about benchmarking at all, then consider a market-matching strategy using index funds. This will allow you to stop asking how your investments are doing and focus instead on the more important question: Am I making adequate progress toward my lifestyle goals? Now that is a true benchmark for successful performance!