INVESTING WITH CLARITY™ BLOG

Why You Shouldn't Use Benchmarks

July 30, 2013 9:29:00 AM

Portfolio returns are the result of the investment Philosophy and Strategy.

NEPSIS

Let me begin by asking a simple, fundamental question... What is more important to an investor: achieving a return that 'beats' or 'outperforms' a benchmark, or achieving a rate of return which enables them to accomplish their financial goals?

I believe that most investors would say, achieving a return which enables them to accomplish their financial goals!

So, why is it that so many investors and advisors are focused on a benchmark? For investors, I believe it is because they need a guideline to help them determine whether a portfolio manager is good or not. For advisors, I believe it is due to the assumption that their clients and prospects demand such benchmarks and without them, they would have to justify their recommendations in a more subjective and substantive manner; which takes more time and requires more resources and intellectual capacity.

That's all well and good, but what happens when someone asks their advisor or themselves, How is the benchmark calculated?\, or What securities and %'s make up the benchmark being used? Or even, How do I know if my money manager is performing well, if I don't even know what their portfolio recommendations are based upon? And, more importantly, they may ask, What do I own and why do I own it?

Frankly, if achieving a financial goal is more important than a benchmark, why are investors and financial advisors transfixed on them?

This leads me to the point that, I believe, many investors do not understand the fundamental concept of Risk Adjusted Return. In other words, how much risk am I taking to make the rates of return I am getting? Instead, many investors focus on past performance as opposed to knowing which companies they presently own and why.

Maybe that is why according to S&P, very few fund managers are able to repeat top-half (notice, I say top-HALF) or top-quartile performance consistently. In fact, according to a study conducted by AAII (American Association of Individual Investors), almost 50% of portfolio managers that provide the highest level of alpha over time (greatest amount of return relative to risk), under-perform stated benchmarks almost 50% of the time!

Below are a couple of additional interesting statistics I believe confirm this belief (according to S&P Analytics):
1. For the five years ending March 2012, only 5.23% of large-cap funds, 5.46% of mid-cap funds and 5.14% of small-cap funds maintained a TOP-HALF ranking
over five consecutive 12 month periods.

2. Looking at longer-term performance, only 5.97% of large-cap funds, with a top-quartile ranking over the five years ending March 2007, maintained a
top-quartile ranking over the next five years. Additionally, only 4.35% of mid-cap funds and 15.56% of small-cap funds maintained a top-quartile performance over the same time period.

So, at the end of the day, is following a benchmark really that important?

I would argue, no! I believe following your investment goals and sticking to the knitting become far more important to an investors in achieving their long-term goals than following short-term returns and gauging their portfolios to a benchmark.

Investors have a tendency to move money from one manager to another with the expectation of greater performance. But, what does performance really mean? Is performance assessed over 3 months, 1 year or 3 years?

The fact of the matter is, statistically, investors potentially INCREASE THEIR INVESTMENT RISK when they move from one manager to another.

How is it they increase their risk? Below are three good reasons why.

1. Investors do not have a clear and concise reason for making the change in money manager, except for historical performance.

2. Investors don't know what and how much of what they sold and don't know what and how much of what they are buying; a lack of investment Clarity.

3. They move their money all out and all in without an execution strategy of what is being bought and what is being sold; again, no investment Clarity.

Of course, I am not advocating that an investor should not move from one manager to another. Obviously, there can be reasons why such a move should happen. However, what I am saying is that, if you are going to move from one manager to another, you should, as a business owner would, have a fundamental understanding of what you are really selling and really buying.

I believe following benchmarks can enhance the investor's desires to chase returns and as the statistics bear out above, that may not be the best strategy!

Ironically, at the end of the day, investors in equities are business owners - they own a piece of a company. Therefore, the one question I must ask is, Do most successful business owners run their businesses in the same, ill-informed manner?

The answer to this is an unequivocal NO! Investors should know what they own and why they own it.

At Nepsis, we call this Investing With Clarity.


Mark Pearson

Mark Pearson

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