Are investors looking for success in the wrong places?
Photo: Jorge Diez Recio. Source: Morguefile
There’s an old story about a man searching for something under a streetlight. A police officer comes by and asks what he’s lost. The man replies that his keys fell out of his pocket 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.
Are investors looking at returns “where the light is”? For years we’ve compared our portfolio results to a benchmark, like the S&P 500 or Barclay’s Aggregate Bond index. We’re encouraged to do this by the investment industry, which compares its recent results relative to the market. The SEC even requires mutual funds to show fund performance next to an index. And it’s easy to produce a graph of relative performance, like this:
Source: College Endowment Offices, Bloomberg
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 clients take the risk, while the manager gets the credit.
And even more significantly, relative performance ignores the investor. What do they need? It depends on the client. Some are looking for extra cash-flow; some want their money to grow for a future need; many want a combination of the two. And almost everyone has a longer time-horizon than the 1, 3, and 5-year comparisons in the literature.
Understanding portfolio performance is hard. It requires managers to listen to what their clients are saying, and to what they aren’t saying. It doesn’t fit into a neat box. And it’s tough for marketing folks to plug in a hot new ad-campaign. But it’s what we need to see.
If you want to find your lost keys, 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 stupid index.
Douglas R. Tengdin, CFA