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.
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.