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Tagged: benchmarking

Why Investor Returns Usually Fall Short of Benchmarks

By Scott Roark, MBA, PhD | July 17, 2020

In podcast episodes and in past blog posts (10/25/2019, 4/20/2019) we’ve talked about the importance of benchmarking – comparing the investment performance on a risk-adjusted basis to an objective measure.

At Jim Saulnier & Associates, we use five Morningstar benchmarks that are adjusted based on risk tolerance.  The benchmarks are for Conservative portfolios (20% equity, 80% fixed income), Conservative Growth portfolios (40% equity, 60% fixed income), Moderate portfolios (60% equity, 40% fixed income), Moderately Aggressive portfolios (80% equity, 20% fixed income) and Aggressive portfolios (95% equity, 5% fixed income).  The Morningstar benchmarks we use consist of around 15-18 individual holdings that are a mix of domestic equity, international equity, large cap, small cap, mid-cap, long-term bond, intermediate bond, short term bond, international bonds, REITs, TIPs, etc.

We have designed our five “Convenience” portfolios to mimic these Morningstar benchmarks.  Jim has repeatedly stated in podcast episodes and in meetings with clients that we do not expect to beat the benchmark, but instead we fully expect to trail the benchmark to at least a certain extent. The reason is that there are several factors that act as a “headwind” for the investor and can mean their performance will not match the performance of the benchmark.  Below is a discussion of the biggest factors.  While this list is not an exhaustive list of everything that can hinder performance, it will touch on the main reasons that an investor might not see the same returns as the benchmark returns they are tracking.


The most obvious reason that an investment generally lags a benchmark is the fees involved.  These would include, but not necessarily be limited to, fees on the mutual fund or ETF that is used, fees from an investment advisor, fees paid to a broker-dealer and brokerage wrap fees.  A quick example with worst case numbers will quickly show why performance might lag a benchmark by quite a bit.

Assume that you have a relationship with a financial advisor that charges an Assets Under Management (AUM) fee of 0.75% per year.  This advisor outsources investment management to a 3rd party who creates a portfolio that is consistent with the risk tolerance of the client.  This investment manager would also charge a fee – let’s assume 0.40% per year.  Finally, there are likely fees in the mutual funds or ETFs held in the investment account.  Let’s assume that the funds are actively managed funds and that the fund fees are close to the average for large-cap stock funds and are equal to 0.85% per year.  All together these fees add up to 2.0%.  This means that if the investments earned 6.0%, you netted only 4.0% after paying the fees.  Even if the investment choices were perfectly aligned with the benchmark, you as an investor would trail the benchmark by 2% per year because of these fees.


Even if fees were not part of the equation (there are funds and ETFs available now that are 0% fee index funds), there are still reasons your performance may trail a benchmark.  The timing of the investment additions or cash withdrawals will affect the performance.  If you are dollar cost averaging and making additions to your investments each month, then the part of returns that occur later in the year have a bigger impact then the part of returns that occur earlier in the year.  The reason is that you have more money in your account being affected by the return.  Say the return for January is -3% and the return for December is +3%.  If you have been adding money along the way, you will have more invested by the time December comes around and it will help your “dollar-weighted” performance.

On the other hand, if you are in retirement and making consistent withdrawals then the sooner bad returns happen, the worse it is for you.  This is the whole idea behind sequence of return risk (see 08/02/2019 blog post).

Regardless of whether you are adding money or withdrawing it, the simple fact that you have cash flows coming in or going out will cause the returns you experience in your account to be different from the benchmark which assumes that the only additions would be from reinvested dividends or interest.

Investment Composition

A third reason your returns might not match a benchmark is that the particular investments you have don’t exactly match what is in the benchmark.  This might easily happen if a large-cap fund manager for an actively traded fund has different sector weights than the S&P 500 index (which we’ll assume is the appropriate benchmark).  Perhaps she even holds the same 500 stocks as the S&P 500 index.  She just holds them in different proportions than the index.  If she is “overweight” the good performers, her fund will outperform the benchmark (assuming her fees don’t eat up all the difference!).  On the other hand, she might have decided to be overweight in the sectors that are lagging and her fund performance will be worse than the index.  The difference that is there is the result of differences in the individual holdings in the fund compared to its benchmark.

This might also happen if one is comparing the performance for a conservative allocation fund to a conservative benchmark (like the Morningstar Conservative model portfolio).  Perhaps the conservative allocation fund manager has decided to be 24% equity and 76% fixed income as compared to the 20% equity, 80% fixed income in the benchmark.  In this case, if equities outperform fixed income, this fund will do better than its benchmark.  It will have a different composition, it will entail more risk, but it will compare favorably to its benchmark.


Yet another reason that investment performance in your account might be different from its benchmark is due to rebalancing.  Typically, a benchmark will involve systematic rebalancing to determine performance.  For the Morningstar portfolio benchmarks that we use the rebalancing occurs on a monthly basis.  If a particular investor’s account isn’t rebalanced on the same schedule, this could again create differences in performance over the course of a year.


The final reason I’ll mention in this post relates to taxes.  This is more of a stealthy reason for performance difference because taxes are rarely if ever paid out directly from the investment account.  However, if there are dividend payments or interest income or capital gains distributions that occur in a taxable account, there will be an increase in the tax amount an investor pays because of these gains.  This is effectively reducing the performance of the account compared to its benchmark where the returns reported are not affected by taxation.

For all the reasons listed, and probably a few more that aren’t listed, it is unlikely that your investment performance will match the performance of the benchmark you have chosen.  But it is important that you understand how big the difference is and what is causing the differences.  Are you being killed by fees?  Is your investment selection very different from your benchmark?

The goal at the end of the day is that your performance over time is close to and perhaps slightly lower than the performance of the benchmark.  However, ideally you would see a very high correlation between your performance and the benchmark’s performance.  That will mean that you have invested in a way consistent with your goals.

Measuring Portfolio Performance

By Scott Roark, MBA, PhD | October 25, 2019

Jim and Chris spent some time discussing benchmarking in a recent Q&A podcast episode. It may be helpful to get in writing some more of the important ideas around this critical aspect of investment management.

Measuring Portfolio Performance

It is critical that a benchmark is used, because without benchmarking there is no objective measure of portfolio performance.  In virtually no other area of life would you accept that – so why would an investor (or an advisor) not measure portfolio performance?  There are a few reasons, and none of them are very good from an investor’s perspective:

  • The performance of the portfolio is lagging an appropriate benchmark. This simply means that the investments are underperforming – that an investor is not doing as well as a benchmark.
  • The comparison of an investor’s portfolio with a benchmark will highlight the impact of an advisor’s fees on a portfolio’s returns. One of the uncomfortable truths of paying advisor fees (along with other fees) that are between 1-2% is that those fees are a direct drag on the performance of your portfolio.  In a world where you might expect a portfolio’s performance, without fees, to generate 5-6% per year, a 1% fee means that 15-20% of the gains you might otherwise have are gone.  And if you have 2% in combined fees, now you’re losing 30-40% of your potential returns over the long-term.
  • Using a benchmark might raise difficult and uncomfortable questions. Especially if the answers to those questions are found in reasons 1 and 2 above.  But there are other reasons a portfolio might lag a benchmark that aren’t as bad.  And an advisor should hopefully be willing to address those questions with a client who is interested.  Some other reasons a portfolio’s performance might be different than an appropriate benchmark is the fact that benchmarks are devoid of economic reality.  That is, the benchmarks typically do not include custody fees, taxes, trading fees, management fees, advisory fees and they assume frequent rebalancing and an otherwise static investment amount.  So if you are putting money in, or taking money out of your investment you will differ.  If you have to pay trading fees or taxes, your performance WILL be below the benchmark.

What Else to Consider

So when you benchmark, what is it that you are really trying to determine – or what do you really care about as an investor?  There should be things beyond just the return that your portfolio is earning.  While that “headline number” catches a great deal of attention, there are other considerations that should be addressed as well.  First among these is the risk of your individual portfolio compared to an appropriate benchmark.  If you think you are a conservative investor with a conservative portfolio, but find out that your standard deviation and your beta are more consistent with a moderately aggressive portfolio then you know you are taking on too much risk.  There has been a disconnect between what you wanted and what you have.

Another measure that is important in benchmarking is a correlation coefficient (also called “R-squared”).  Without getting too technical, this scaled measure shows how closely two items move together over time.  So having a high R-square (above 95) means that a portfolio is tracking its benchmark pretty closely.  If you have a low R-square (maybe 50-60), then that is an indication that you have two very different things.  If you are trying to mimic a conservative allocation fund, but your R-squared measure with a conservative benchmark is 50, then you are doing a poor job of matching.

At our firm, we track performance by comparing to benchmarks for our five convenience portfolios.  We have the following portfolios that vary by the risk associated with their asset allocations:  Conservative, Conservative Growth, Moderate, Moderately Aggressive, and Aggressive.  Each of these portfolios has different characteristics and different risks.  When a client chooses one of these portfolios, they should expect performance that closely matches the performance of the benchmark.  Of course, there will always be SOME differences, but understanding the differences is key for any investor.

Using Tracking Difference to Analyze Performance

By Scott Roark, MBA, PhD | August 30, 2019

Benchmarking vs. Tracking Difference

In a recent podcast episode (Edu #1925), we talked about benchmarking investment performance.  It is important for investors to know how well they (or their managers) are doing with the investment decisions they make.  One of the reasons that managers may not like to benchmark is that historically, relatively few managers consistently beat their benchmark.  There are a variety of reasons it is difficult to beat a benchmark.  Benchmarks are typically tied to an index which means it is a passive investment choice.  The problem with an index is that you can’t technically invest in one – when you buy an S&P 500 ETF, you are buying something that is very close to the index, but not the same as the index.  An index doesn’t have trading costs, taxes, manager fees, rebalancing costs and a variety of other possible drags on performance.  But you can generally feel pretty good when you buy your ETFs because the correlation between it and the index you are trying to mimic is usually higher than 99%+.

A similar way of stating the performance of an ETF and an index are very close is to look at their tracking difference (the difference between the index performance and the fund/ETF performance).  A good ETF or index mutual fund will have a very low tracking difference – measured in 1/100ths of a percent.  So for example, say the Russell 2000 index had a return of 7.59% and your Russell 2000 ETF had a return of 7.52%.  The tracking difference, in this case, would be 0.07%.  If you are trying to mimic the performance of an index by purchasing ETFs or mutual funds, the tracking difference is an important piece of information.

Using Tracking Difference

There are dozens of funds and ETFs (from dozens of fund companies) that track the S&P 500 for instance.  An investor might reasonably expect that when they purchase an S&P 500 fund, they will be getting a performance that very closely resembles the results of the S&P 500 index.  With many funds, that is what you are getting – something that very closely resembles the S&P 500 and has a tracking difference of 0.10% or less.

However, there are funds – typically ones with high expense ratios – that have relatively high tracking differences and really aren’t giving investors what they should be expecting.  One notorious example of an S&P 500 index fund has an expense ratio above 2.3%.  Compare this to many funds and ETFs that track the S&P with expense ratios of less than 0.1% and you can start to see why the fund’s returns will be well below the benchmark and there will be a large tracking difference.

What Else to Consider

In closing, I’ll mention one last factor that is related to investment performance – particularly for mutual funds.  That is the tax-efficiency of the fund.  This is related to the buying and selling of the fund and how that affects the taxable distributions from the fund each year.  If you are holding your investments in a tax-advantaged or qualified account (an IRA/401k/Roth), you may not care that much about this.  But in a taxable brokerage account, taxes represent a very real decline in investment performance.  The fund I mentioned above that had expense ratios (for an index!) over 2.3% also had an annual turnover of 157% (versus 4% for more well-run index funds) – there was a lot of buying and selling.  All this trading means that come tax time, there will likely be insult added to injury and the after-tax performance will be VERY far away from what the index return was.