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THE BEST WAY TO WIN a contest for the largest tomato is to paint a cantaloupe red and hope the judges don’t notice, or so says an old adage.
What does that have to do with managing money? Newspapers and magazines frequently interview mutual fund managers who have beaten their competitors, and perhaps the S&P 500 as well. Fund-management firms will even run ads touting the performance of these funds.
These interviews sometimes prompt me to do my own research. I frequently find that a manager did indeed beat the S&P 500, but that’s the wrong benchmark for the fund. If it’s a growth fund, I compare its performance to a growth index. For a value fund, I use a value index. The fund’s performance tends to suffer by comparison.
I called one of these fund companies to discuss the benchmark it used. It measured its fund against the S&P 500, and yet the fund’s manager had been buying growth stocks for the past 10 years. The fund’s representative said, “We’re just buying the best stocks. We don’t look at the index. We own Berkshire Hathaway. How can you call us a growth manager?”
I’m not sure how one company, even one built by a famous value investor, makes a big difference. I generally find that any manager who shows consistent annual returns above his or her benchmark is using the wrong index.
It’s easy to find the correct index for any fund. Morningstar’s site, where much information is available for free, will show a fund’s performance against its correct style benchmark, as well as its performance against its fund peers.
Given that the historical data show that most managers fail to beat their proper benchmark, what should an active-management firm do? Don’t compete against an index. Firms have devised products that make their relative performance less transparent.
Consider separately managed accounts (SMAs). With an SMA, you own individual stocks or bonds, and the manager buys and sells them, subject to your constraints. You might instruct the manager not to buy your employer’s stock, or to avoid gaming stocks, oil companies or other stocks you deem undesirable.
The manager invests around these constraints. On a positive note, SMAs may offer lower fees than a mutual fund and better control over taxes. You can ask them to minimize realized capital gains, for example.
But what happens when you try to measure an SMA’s performance? The managers will say that, given your constraints, they couldn’t sell a stock before it sold off, so they underperformed this quarter.
That said, if not owning more of your employer’s shares is worth some performance offset, maybe that underperformance is okay. Minimizing taxes is always good, too, because it’s after-tax performance that truly matters.
Many SMAs are managed with investment characteristics similar to one of the same firm’s mutual funds, so you can measure the SMA’s performance against that fund and its benchmark index. That way, you’ll know whether the manager underperformed, rather than blaming the SMA’s constraints for its underperformance.
It’s not just fund managers who are painting cantaloupes red. If you use financial advisors, they’ll want to demonstrate they’re adding value as well. One way is to construct a diversified portfolio with funds specializing in value and growth shares.
I was once presented with a visually beautiful investment proposal. Each of the 12 funds presented had bested its benchmark over the previous five years. The list included a pick in each sector of the U.S. stock market’s style box, plus international and fixed income.
I asked how the total portfolio performed against its target, which for me was 60% S&P 500 and 40% Bloomberg Aggregate Bond Index. “Oh, let us run that and come back to you,” was the answer. It turned out that the portfolio in total didn’t beat my target in either raw performance or risk-adjusted return.
The 12 parts looked good individually. While it was impressive that the value manager had beaten the value index and the high-yield bond manager had outpaced the high-yield bond index, what mattered most to me was whether they could collectively beat the 60-40 benchmark. The handsome printed proposal had tried to divert my attention to the parts and away from the whole portfolio.
Imagine going to a restaurant. The server explains that the salad ingredients are all from local farms, picked fresh that morning. What matters to me, however, is how the chef assembles my salad. Only when I put the fork in my mouth do I know if he bought a nice beefsteak tomato or a cantaloupe painted red.
Do you know the track record of the advisor who is choosing your funds? While my advisory firm insisted on at least a five-year track record for the fund managers it invested with, it had no such requirement for the advisors recommending funds to me. When I found that out, I chose to invest in index funds.
Whether you have an advisor choosing funds or you choose them yourself, you should always ask: What’s the right benchmark for judging performance? For mutual funds, I suggest looking at Morningstar. For other portfolios, look at performance of a simple stock-bond mix that matches your portfolio’s stock-bond mix.
Matt Halperin, CFA, is the founder of Act2 Financial, an app that helps seniors avoid financial fraud. For 30 years, he worked as a portfolio manager and risk manager at large U.S. money managers. Matt currently serves on the investment committee of two endowments. He has a BA and MBA from the University of Chicago, and resides outside of Boston. Matt’s previous articles were Taking the Keys and Where It Nets Out.
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While I completely agree with the author’s sentiment regarding use of an appropriate benchmark, and have significant professional experience in this regard, I would caution against using Morningstar as the ‘holy grail’.
Morningstar’s assignment of a style benchmark is based on its assignment of a category. Sometimes it’s hard to accurately pin down the right category, and sometimes, IMHO, Morningstar is just plain incorrect.
Case in point — VEXAX, Vanguard’s Extended Market Index fund. M* has had this assigned to MidCap Blend for at least 10 years, so the style benchmark is US MidCap Total Return. The issue is that the fund is over 60% Small + Micro, 32% Mid, 4.5% Large, whereas the benchmark is 94% Mid, 5% Large and 1% Small. The 5Y factor profile supports that this should be considered a SmallCap fund. This also calls into question the validity of the peer comparison data for this fund, and as a derivative, the Star rating.
False Comparisons, indeed!
A great article!
Great opening line. An excellent article that points out a very common truth. If you don’t like what is par for the course, just set your own, so your score will always look better against it.
This reminds me of how executive pay is sometimes set. When a CEO has to negotiate a new employment agreement, he or she will often recommend to the board that it use a particular consultant (or his or her most supportive board member will make that recommendation.) That consultant, desirous of future business, will often cherry-pick among other CEOs’ salaries in comparative companies to come up with a recommendation, and that recommendation will usually be that the CEO should earn a lot more. Elon Musk won’t show up on the list of comparables, of course, but the conclusions will still lead to more, more, more.
Matt, I found your article enlightening. I have 2 SMA’s, a global growth equity account and a municipal bond account. You are correct, the management fee is less than most similar mutual funds, although not ETFs. Where the equity account shined was in 2022 market sell off. In October of that year I had the SMA sell 10 of the 27 companies I owned for the tax loss and bought a MSCI All Country World Index ETF to stay-in-the-market. 31 days later, to avoid violating the Wash sale rule, I had the SMA sell the ETF and buy back those companies. This proved very advantageous. An advantage of the muni bond SMA is 50% of the bonds are from the state I reside so I pay no federal or state tax on the interest earned on those bonds. Also, the SMA doesn’t have to sell bonds when the environment is unfavorable due to redemption requests common with mutual funds. As for evaluating performance, your advice is spot on. I can compare my results to the SMA company’s mutual fund that hold most of the same companies. Although not an apple-to-apple comparison the MSCI All Country World Index ETF has out performed my SMA. One reason is the index holds NVIDIA, Meta and a few other high fliers, which my SMA doesn’t hold, but are held elsewhere. When compared to a National Muni Bond ETF, my SMA has also slightly under performed, although the ETF‘s credit quality, duration and holdings differ. I can instruct my SMA to lower the credit quality a little and extend the duration to try and pick up a little more yield.
I have frequently questioned the relationship of benchmarks to my investments, but I lack the skill necessary to do what you just provided. I appreciate your effort here, very informative.
I couldn’t begin to say the last time I compared the performance of my own portfolio to its benchmark. It’s probably pretty close as my portfolio isn’t anything special, but more granularity doesn’t matter to me because I’m not out to beat the benchmark.
While this article is critical of many financial advisors it still appears to promote the notion that some advisors are “adding value” by beating their benchmark index over the long run and that investors will be able to successfully identify those who have done so due to skill rather than random luck. For me, the takeaway is to follow the author’s decision to invest in index funds.
“On a positive note, SMAs may offer lower fees than a mutual fund”
Really? Have you looked at the fees for index funds (and ETFs) at Vanguard and Fidelity lately?
While the sentence could be more clear, the context of the article leads me to believe the use of “mutual fund” and “fund” refer to actively managed funds. The use of “index” or “index fund” refers to index funds.
Index funds are also mutual funds.
I am a big proponent of paying for Morningstar premium membership as they provide a plethora of excellent information. However once I enter my portfolio manually (I don’t link my investment accounts with any website for security reasons) and then look for an appropriate benchmark with my allocation to compare performance there are none as the benchmarks are all stock based such as S and P, Dow etc.. As a result I use Morningstar’s and Vanguard’s target funds for my benchmarks. Since Vanguard’s are set up in five year increments it there is usually a fund that matches my allocation.