When considering investing with a particular financial planning firm or mutual fund consider looking at what benchmark they’re comparing their returns (disclosure: the funds we use are the benchmarks).
It’s pretty easy for a mutual fund company or adviser to tout their funds when they have beaten the benchmark over a certain period of time. For example, I had the opportunity to look at a client’s investment performance report that they had with another company. Written across the top in the adviser’s handwriting was the phrase, “Looks like we beat the benchmark.”
And it was true. They had beaten the benchmark. But after looking a little bit harder at the fine print the benchmark wasn’t even close to the funds the client was invested in. In fact, it was grossly different. In other words, the adviser was comparing their portfolio recommendations consisting of roughly 90% equities and 10% bonds and cash to a “benchmark of 40% equities and 60% bonds. And this was for 2013 when equities finished very well and the S&P 500 was up 29.6%.
What was even more interesting is that they only beat the benchmark by just over 1%. At first, the client thought that their adviser was doing an excellent job; picking the right funds, allocating and managing the money to beat the benchmark.
No one likes to give bad news, but as professionals we have to sometimes be the bearers of bad tidings. After pointing out the orange that was the benchmark to the apple of the investment portfolio the client started to understand that is wasn’t representative of a true benchmark. Additionally, their indifference turned to suspicion when I also asked if their returns were net of the adviser’s fees. They were not.
So in reality, the apples to oranges comparison that looked good at first, turned out to be returning less than the benchmark.
The takeaway from this piece is to make sure that when a fund manager or adviser is telling you about expected or realized returns as compared to a benchmark, make sure they are using an appropriate benchmark that realistically compares and uses the same types of securities they’re recommending (i.e. a large cap mutual fund would be compared to the S&P 500). The next question to ask is whether the comparison is net of fees. Then proceed accordingly.
Sterling Raskie, MSFS, CFP®, ChFC®
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Hi Sterling. Makes great sense. I like your approach. Thank you!
My pleasure! Thanks for commenting!
Hi Sterling. When you say “the funds we use are the benchmarks” I’m wondering if you’d be willing to elaborate on this. It sounds then as if you’re measuring yourself against yourself. No? I’m interested in learning more about what works for you as an appropriate benchmark both for the initial assessment of a portfolio (and why) and also what’s appropriate (if it’s any different) going forward as a clients work with advisors. I have some thoughts of my own but am curious to learn what otheres do. Many thanks!
Hi Lisa,
Great question. Essentially, we are using index funds which, in and of themselves are benchmarks. The slightest difference being that the true index won’t have fees or transactions (other than if a company needs to be replaced). So this will be a slight difference from the fund to the true benchmark. While we’re not necessarily measuring against ourselves, we’re more so managing investor emotions and expectations. The benchmark then is simply the weights of the different funds in our portfolios. A simple illustration would be if we had a portfolio that was 50% S&P 500 fund and 50% bond index fund, the the “benchmark” would be made up of 50% S&P 500 and 50% Barclays Capital Broad Market. In the end, there’s not a benchmark we’re trying to beat. It’s trying to adhere to that benchmark as much as possible (less fund expenses and fees). Overall, the appropriate benchmark is the individual client’s capacity for risk and finding the right portfolio to match. I hope this helps and makes sense.