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Understanding the Underperformance Question
Tuesday, August 28, 2012
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I've always felt that being a financial advisor is one of the most responsible and important careers-with the potential to positively impact the financial lives of the clients who trust in your advice. But over the course of 17 years, I've been shocked at how few advisors really know how to respond to this question: "Can you explain the underperformance of your investments?"

While the question is valid, it begs the response, "Underperformance compared to what?"

You really can't answer a question about underperformance without first examining the investment approach and the benchmarks used to compare returns.

First decision to be made:  Active or Passive?

If you employ an active management investment strategy, you are hoping that the manager you've hired can accurately identify the right securities and/or when to be in the markets at the right time. Your intent is to beat the market.

As the chart below shows, historically, the majority of active managers have had a tough time outperforming their indices.

When you use a passive management investment strategy (think indexing or Asset Class Investing), your goal is to get the market rate of return for each asset class, rather than try to beat the market.  

If you compare individual investments, like mutual funds, you must first identify the asset class of the fund and then compare it to the respective asset class return. If the mutual fund had a lower return than the asset class, then you underperformed.  

The next time someone asks you to explain your "underperformance," determine if your approach was intended to beat the asset class or match the asset class before you respond.

Second decision to be made: What are the benchmarks for comparing returns?

Many people mistakenly think the Dow Jones or S&P 500 is "the market." This would be true if your portfolio were made up of only U.S. Large Cap stocks! However, a diversified portfolio is built with many different types of assets, not concentrated in one. It's important for your clients to understand the difference, and why diversification is so important.

Let's take a look at the randomness of returns in the chart below:

As the chart shows, every year there is a different winner and a different loser-and the asset classes in between behave just as randomly. When you employ a diversified strategy you strive for less volatility by owning a broad variety of asset classes.

Since one of the goals of diversification is to avoid the highs and lows that accompany investing in one asset class, it is statistically impossible for a diversified portfolio to ever outperform the top asset class for any given year. On the flip side, a diversified portfolio will always outperform the worst asset class in the portfolio.

Some clients may suggest excluding the worst performing asset classes from the portfolio. But as the chart shows again and again, the performance of each asset class from year to year is random. Today's bottom performer can easily be tomorrow's top asset class-and vice versa.

It may be better to own a broad variety of asset classes, allocated according to the client's risk tolerance and time horizon, and put your trust in capitalism's long-term potential to create wealth (regardless of which country that may come from).

The good news: when you take the time to teach your clients so they really understand this they will ask about underperformance less often.

The need for client education, even with relatively sophisticated clients, has never been greater.  For example, only half of Americans polled in a national survey on financial literacy understood that buying a stock mutual fund is typically safer than a single company's stock, while one-third had no idea.[1]

In summary, the next time you ask- or prepare to answer-a question about underperformance, think about the two decisions: Was the strategy intending to beat or match an asset class and are you using the proper benchmark for comparison?

[1] www.reuters.com/article/2012/02/16/us-column-miller-literacy-idUSTRE81F1YN20120216

__________________________

Steve Atkinson, CFS, is Executive Vice President of Loring Ward, Head of Advisor Relations, providing support and coaching to help advisors grow their businesses.

 

 

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