This is a true story. It is about investment advisors and how they mislead clients and prospects by comparing their account performances improperly with indexes. This is not a story I enjoy telling, but it unfortunately happens all too frequently in the advisor marketplace.
I recently participated in a conference for retiring airline pilots. My company was there as a sponsor and I was a speaker on index fund investing. There were several other investment advisor firms at the conference, also as sponsors and speakers.
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I happened to strike up a conversation with a principal from one of these competing firms. After some pleasantries, I asked what strategy his firm used to manage portfolios. He said his firm was an active manager and that they used a variety of strategies.
"How's your performance been?" I asked.
"We beat the S&P 500 by 5% over the past decade."
"The S&P 500?" I asked. "I assume your firm is a large-cap U.S. stock manager?"
"No. We invest in bonds as well as commodities and foreign stocks."
Stunned that I would say such a thing, he shot back, "Because that's the index our clients want us to use!"
He went on to defend his position, "Look, you and I both know the people at this conference are not sophisticated. They only want to know if we 'beat the market.' So that's what we tell them." (Find out why an apples-to-apples comparison is so important in Benchmark Your Return With Indexes.)
"So you report what makes your returns look good even though the S&P 500 has little relevance to what you are actually doing," I said. "And then you say this is what your clients want rather than trying to educate them."
With that, our conversation abruptly ended.
It's very common for advisors to use inappropriate benchmarks in client reports since advisor performance reporting practices are largely unregulated by the Securities and Exchange Commission. Results are often reported before deducting management fees and then measured against an easy-to-beat index that may change - if any index data is shown at all. By design many clients are kept underinformed. They never really know how well or how poorly they are performing. It's really a sad situation.
Red flags should go up when an advisor claims to be outperforming his stated benchmark by four or five percentage points per year, because that just doesn't happen; no manager is that brilliant. More often the index being used is inappropriate.
Ethical advisors use appropriate indexes. If an account is holding bonds, then the benchmark for the account includes bonds. If an account has a foreign stock allocation, then the benchmark includes a foreign stock allocation. If a benchmark doesn't exist that mirrors a client's investment strategy, then the advisor creates a custom blend based on an appropriate mix of indexes to match how an account is being managed. (Learn how to determine the difference between a good and bad advisor in Find The Right Financial Advisor.)
Every advisor knows the proper way to report client performance, and which indexes make an appropriate benchmark. All it takes is for the advisor to be ethical and report the right way. It is a matter of choice. It's a matter of professionalism.