Kitces: Advisor benchmarks are essential — and flawed

Benchmarking is a basic measure of accountability, but the process of setting benchmarks is flawed. If a manager’s performance is pegged to the overall market, then they may just benefit from the underlying results of a well-performing asset class. And when the benchmark is set against the client’s own investing goals, positive results can still hide poor decisions made by the manager.

That’s not to say benchmarking should go away. Instead, managers and their employers need to take a more holistic view of what it means to perform well.

In business management, benchmarking studies help us understand how the performance of our business measures up to that of our peers. They’re particularly helpful when determining whether we’re spending more or less than others in overhead or technology, whether we’re generating a typical income for our efforts and whether our pricing is competitive.

In the context of investments, benchmarking is used to evaluate whether a manager is outperforming the passive index alternative. Of course, benchmarking results depend heavily on what you use as the benchmark in the first place. Consequently, having an appropriate one is crucial. This was arguably the greatest contribution of the Morningstar Style Box when it was first developed.

Prior to the style box, equity managers were often compared to the same standard market index, regardless of whether they tilted toward value or growth, large or small stocks. What was considered great performance — i.e., beating the market — was actually just the result of having a small-cap focus when that whole segment was outperforming. By controlling for the style of the manager in the first place, it became feasible to have a more appropriate and better-targeted benchmark — one that could effectively differentiate between a good small-cap manager and one whose performance just looked good.

Of course, the underperforming manager might not have wanted to be benchmarked simply because it would draw attention to their underperformance. Yet in practice, benchmarking is crucial precisely because it creates accountability.

When not applied effectively though, benchmarks can be blunt — and sometimes unfair — tools. Investors can judge too quickly based on short-term performance relative to a benchmark, and in order to beat a benchmark, it’s necessary to own investments that are materially different from it. In a cruel irony though, doing so puts portions of the portfolio at risk — and making a wrong bet against the herd is one of the fastest ways to get fired.

This has led to the revelation that a non-trivial number of mutual funds have very little active share and are effectively just closet indexing. More generally, many investment managers fear that they must stay in their box, given the performance and career risk of deviating substantially from their benchmark. This is true even though hugging the benchmark — while charging ongoing fees — creates a virtual certainty that the manager will underperform by the amount of their fees. As for a bad manager, it’s likely still better to be fired slowly and in the meantime earn management fees than to place active portfolio bets that may just hasten their demise.

Benchmarking is creating significant frustration for advisors in part because it seems to be getting more difficult to find alpha. This is true for advisors who simply implement passive portfolios as well as for those who don’t want to risk being fired for what proves to be short-term underperformance. After all, it’s not really about whether the client beats the markets per se, but whether they generate the returns necessary to achieve their planning goals.

BENCHMARKING TO GOALS
To understand the potential problem with benchmarking clients to their goals, imagine an investor who was getting started with an advisor 16 years ago.

It would have been 2002, just after the bottom of the tech crash, where the investor had fired their previous advisor and hired a new one, with the goal of retiring in 20 years. Assume that by the end of 2002 the investor would have had about $250,000 saved, with a goal to retire with $1.5 million in 2022.

A planning projection at the time would have revealed that retiring after a 20-year time horizon was feasible by saving $500/month and earning an 8%/year average annual growth rate on a balanced growth portfolio, a typical return projection at the time. Accordingly, the advisor created the following projection for the client to track — i.e., benchmark — their progress toward the goal.

Michael Kitcs benchamarking retirement goals IAG 072018

The advisor then invested the client into a 60/40 diversified portfolio of large-cap U.S. stocks and intermediate-term government bonds to achieve the desired rate of return. As it turned out though, over the subsequent five years the post-tech-crash bull market generated more than enough of a return to keep the client ahead of their goal benchmark.

But in the next five years, the severe market downturn caused the client to fall well below the original goal benchmark, producing a substantial shortfall relative to the benchmark return.

Fortunately, in the past five years the sustained market rally has brought the portfolio forward to the point that the investor is again approaching the original goal benchmark.

Nonetheless, the high volatility over the past 15 years means the advisor has gone through substantial stretches of both underperforming and outperforming the goal-based benchmark.

The key distinction is that it wasn’t really the advisor or their investment recommendations that produced these long stretches. Rather, it was the market itself. The relative strength of the advisor’s portfolio compared to the client’s goal benchmark was really nothing more than a comparison of market returns to an 8% absolute straight-line-return benchmark.

Through this lens, benchmarking to goals amounts to little more than evaluating performance of the markets relative to a long-term absolute return goal — that is, the assumed growth/discount rate of the retirement or other goal projection.

Ironically, this can prove even more of a challenge. It’s tough enough to manage clients who want good returns in bull markets and no losses in bear markets. It’s even harder to maintain a steady-state absolute return benchmark of +8%. That’s why an advisor shouldn’t receive any credit or blame for the results in this scenario. Market returns are what they are.

MEASURING PROGRESS
The second challenge is that benchmarking fails to achieve the actual purpose of the practice. That is, determining whether the investment advisor or portfolio manager is actually adding value.

Imagine two advisors were hired at the beginning of 2012 to manage a client’s retirement funds. The client hopes to retire in 10 years and needs a 7%/year return to achieve the goal.

Advisor No. 1 puts the client into a Fundamental Indexing equity fund (PRF), paired with the Double-Line Total Return Bond Fund for a fixed income allocation (DBLTX). Advisor No. 2 buys a series of higher-cost and actively managed funds that haven’t performed as well since 2012, including Eaton Vance Tax-Managed Value Fund (EATVX) for the equity allocation and STAAR General Bond Fund (SITGX) for the bond allocation.

Benchmarked solely against the client’s goals, both advisors outperform, which helps keep the client on track to meet their goals.

However, this performance had little to do with the advisors themselves. Instead, the results were driven almost entirely by the raging equity bull market that has been underway.

On the other hand, when the advisors are benchmarked relative to what a simple 60/40 portfolio of an S&P 500 index fund and a Barclays Aggregate Bond Index fund could have achieved over the same time horizon, a different picture emerges. Indeed, one of these advisors generated substantially inferior results in a manner that was completely masked by benchmarking to goals — and is not evident until a proper investment benchmarking process occurs.

As these benchmarking results show, while the client may be well on their way to achieve their goals thanks to the overall lift of the markets, only one of the advisors has actually added any investment value to the equation. The other is actually slowing the client’s progress, as good market returns are masking what is otherwise grossly inferior performance returned by poorly performing fund managers.

EVALUATING ADVISOR VALUE
Ultimately, none of this is meant to suggest that investors shouldn’t have better context for where they stand relative to their goals (with the caveat that investors don’t always actually know what their real goals are in the first place). But evaluating the results of the investor — primarily driven by market returns relative to goals — is different than evaluating the results of the advisor or investment manager, which is all about whether the advisor or manager’s investment process is adding value above and beyond those market returns.

A growing number of advisors derive their value proposition not via market outperformance, but rather via market returns with index funds and providing holistic planning. A benchmarked portfolio will correctly show that these advisors’ results simply lag the market by the amount of their fees, and that they are not adding value in the investment selection process itself — as they weren’t trying to in the first place. That in turn simply means such advisors will or won’t demonstrate their value in the client’s view by the more holistic value they provide.

In other words, benchmarking an advisor’s investment results isn’t necessarily the only way to evaluate the advisor’s value. Nonetheless, to the extent that investment recommendations are even part of what the advisor delivers, benchmarking can and should remain highly relevant when it comes to evaluating the associated investment results — especially for those really doing something in the portfolio that is intended to favorably impact investment outcomes.

Whether we’ve met a client’s goals will always be determined by some combination of market- and advisor-driven results. But recognizing that each has a role also means recognizing that each needs to be independently benchmarked. Investors can always assess their results relative to the goals they set, but they should still be able to benchmark advisors — at least those who aim to add value in the investment process — to an appropriate investment benchmark to determine whether the advisor is, quite simply, doing their job.

So what do you think? Should advisors who manage portfolios still be benchmarked against their investment results? Are there situations where it’s appropriate to benchmark to goals, even if the results are driven by market forces beyond the advisor’s control? Please share your thoughts in the comments below.

This article originally appeared on Kitces.com.
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Retirement readiness Practice management Advisor strategies Client communications Portfolio construction Asset management Holistic financial planning Michael Kitces
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