Are investors looking for success in the wrong places?
There’s an old story about a man searching for something under a streetlight. A policeman comes by and asks what he’s lost. The man replies that his keys are missing and he can’t get back into his house. After a few minutes searching together, the policeman inquires whether the man is sure he lost his keys under the lamp. No, the man replies, he lost them in the park. “Then why are we searching here?” exclaims the officer. “This is where the light is,” replies the man, continuing to search.
Are investors looking at returns “where the light is”? For years they’ve compared their portfolio results to some benchmark, like the S&P 500 or the Barclay’s Aggregate Bond index. They’ve been encouraged to do this by the investment industry, which often touts its recent results relative to the market. The SEC even requires mutual funds to compare fund performance to an index. And it’s fairly simple to produce a graph of relative performance, like this:
Source: Charter Trust Company
But you can’t eat relative performance. When the S&P 500 fell 37% in 2008, it was cold comfort for investors to note that their portfolios “only” fell 33%, even though 4% portfolio outperformance is usually a reason to rejoice. But comparing yourself to an index ignores two major issues. First, it ignores risk. One fund manager put it this way: “It’s easy to outperform. Just load up on high-beta stocks. Since the market goes up more often than it goes down, they’ll do better than the market.” Such an approach makes the clients take the risk, while the manager gets the credit.
And even more significantly, relative performance ignores what clients really need. And what do they need? That depends on the client. Some need income, some need growth, many need a combination. And almost all clients have a longer time-horizon than the 1, 3, and 5-year comparisons in the literature.
Understanding portfolio performance is hard. It requires managers to understand their clients. It doesn’t fit into a neat box. And it’s hard for marketing folks to tout in their latest ad-campaign. But it’s what investors need to see.
If you want to find your lost keys, you need to look where you’ve lost them, not where the light is. And if you want to know how your portfolio is doing, compare it to your actual needs—not some arbitrary index.
Douglas R. Tengdin, CFA
Chief Investment Officer
Leave a comment if you have any questions—I read them all!