Having worked with investment professionals for many years calculating, analyzing and presenting performance returns, I have seen many approaches to using benchmarks.  Sadly, many wealth managers are misrepresenting or using an inappropriate benchmark.

The CFA Institute has published the following list of criteria for a valid benchmark which is part of the CIPM program: measurable, investable, appropriate, unambiguous, reflective of current investment opinion, specified in advance and able to be owned.  To sum it up, it should reflect an appropriate comparison to how the investor’s assets are invested to provide a comparison of how the assets performed.

The following are three common issues I see far too often working with investment professionals.

• Assuming a blended benchmark is most appropriate. Many, if not most, wealth managers position that their investment advice is valuable both from an asset allocation and/or selection perspective.  In fact, many are not even trying to suggest they can pick the best investments and restrict their work to set an appropriate asset allocation target and possibly adjusting tactically.  When using a dynamically blended benchmark that adjusts the weight of your actual allocation to various asset class benchmarks each day or month, a blended benchmark only measures how well you selected assets within that asset class.  In other words, are you a good stock (or fund) picker.  Many managers assume their skillful asset allocation decisions will be reflected in outperformance but sadly they do not.  If you aren’t trying to add value picking the right stocks (or funds), then stay away from a dynamically blended benchmark.  I would suggest a static blend (or policy benchmark) whose allocation does not shift daily or monthly.  Comparing against this type of benchmark highlights both allocation and selection skill.  Criteria failed (not in all cases): reflective of current investment opinions & appropriate.

• Using the price return of a benchmark. We often hear from clients that they want the price return of the benchmark.  The request seems logical at first if an asset (or funds) income is not re-invested in the fund, as in the case of many trust accounts, then wouldn’t you want to compare your performance against just the price return of the appropriate benchmark?  In most cases, NO!  Unless a different portfolio receives the income, which tends to be rare, then the return calculation captures the income return in the portfolio whether or not you re-invest the income in the asset.  Comparing the portfolio against a price return benchmark can mislead your customer into believing you performed better relative to the benchmark than you did in reality.  Criteria failed: appropriate & investable.

• The WRONG Benchmark. This is an epidemic.  Really.  Why do so many wealth managers obsess about how they performed relative to the S&P500?  I believe the answer is because this is the most common benchmark reported in the news and arguably most understood by investors.  I see this benchmark on just about any client report and sometimes it is the only benchmark listed!  Unless you are only investing in large-cap US equities, this benchmark isn’t appropriate.  Most client portfolios are a mix of equities, fixed income, real estate, commodities, cash, etc…  Listing the S&P500 as one of several benchmarks IF it is shown compared to similar assets in the portfolio is certainly appropriate.  Sadly, many misuse it.  Criteria failed: appropriate.

Disagree?  I would love to hear from you!

Marshall Smith( EVP, Services )

Marshall Smith CIPM, EVP of Services, has been with First Rate since 2006. You can follow Marshall on Twitter @MarshallCSmith, or connect via LinkedIn.