False Comparisons

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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