Many people and fund companies still use inappropriate benchmarks for measuring investment performance. Instead of getting truthful results, investors are given a distorted perspective of performance which leads to mistaken conclusions.
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The mutual fund industry’s (NasdaqGS:MORN) widespread use of peer group comparisons is a prime example of using erroneous yardsticks.
Back in 1991, William F. Sharpe warned about this in the Financial Analysts’ Journal:
“Peer comparisons are dangerous. Because the capitalization-weighted average performance of active managers will be inferior to that of a passive alternative, the former constitutes a poor measure for decision-making purposes. And because most peer-group averages are not capitalization-weighted, they are subject to additional biases. Moreover, investing equal amounts with many managers is not a practical alternative. Nor, a fortiori, is investing with the “median” manager (whose identity is not even known in advance).”
Based upon my own informal studies, there are four types of individuals (and institutions) that reject the robust performance comparisons of corresponding passive indices (NYSEARCA:SCHB) and here’s the reasons why:
• Group A: They reject apples-to-apples comparisons because they want to cherry pick benchmarks that skew their performance in an unrealistic but favorable way.• Group B: They reject apples-to-apples comparisons of passive blended benchmarks because they’re like the majority of the financial services industry; lazy.• Group C: They prefer to be secretive about their performance record before investing clients rather than be held accountable for results.• Group D: They don’t measure performance because they don’t know any better.
The flip side of people who want ignore or skew performance results is the constituency that focuses exclusively on performance and nothing else. This is a short-sighted view, however, because it ignores important facts like: How much did risk (ChicagoOptions:^VIX) did the investor take to achieve a certain performance return? How much in fees and taxes did the performance cost?
My experience at analyzing and grading over $100 million dollars via the Portfolio Report Card shows a common thread: If a person’s portfolio grades poorly in the first four categories (diversification, risk, cost, and taxes) it’s almost guaranteed they will score poorly on performance. Put another way, your portfolio’s performance (good or bad) is directly linked to how well you do at managing risk, diversifying, and minimizing cost along with taxes.
But therein lies the problem for most investors: You can’t know what your portfolio’s true performance is if you or your financial advisor (NasdaqGS:LPLA) are using the wrong benchmarks.