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.

Wrap Account Ripoff

Active Management Is Uncompensated Risk

Don't Churn Me

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."

"Then why are you using the S&P 500 as a benchmark?" I asked. "That's a large-cap U.S. stock index. You should use a blended benchmark of global stocks, bonds and commodities."

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.

As in the case with my real-life example, a favorite index for advisors has been the S&P 500, because its performance has been below every other major asset class over the past decade. Virtually any portfolio diversification away from large-cap U.S. stocks would have outperformed the predominantly large-cap S&P 500. All an investor needed was a small allocation to international stocks, small-cap stocks, REITs or bonds - or even cash - and his portfolio would have "beaten the market."

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.

Related Articles
  1. Retirement

    Two Heads Are Better Than One With Your Finances

    We discuss the advantages of seeking professional help when it comes to managing our retirement account.
  2. Economics

    Investing Opportunities as Central Banks Diverge

    After the Paris attacks investors are focusing on central bank policy and its potential for divergence: tightened by the Fed while the ECB pursues easing.
  3. Chart Advisor

    Now Could Be The Time To Buy IPOs

    There has been lots of hype around the IPO market lately. We'll take a look at whether now is the time to buy.
  4. Professionals

    A Day in the Life of a Hedge Fund Manager

    Learn what a typical early morning to late evening workday for a hedge fund manager consists of and looks like from beginning to end.
  5. Stock Analysis

    The Biggest Risks of Investing in Pfizer Stock

    Learn the biggest potential risks that may affect the price of Pfizer's stock, complete with a fundamental analysis and review of other external factors.
  6. Entrepreneurship

    Creating a Risk Management Plan for Your Small Business

    Learn how a complete risk management plan can minimize or eliminate your financial exposure through insurance and prevention solutions.
  7. Investing Basics

    5 Tips For Diversifying Your Portfolio

    A diversified portfolio will protect you in a tough market. Get some solid tips here!
  8. Entrepreneurship

    Identifying And Managing Business Risks

    There are a lot of risks associated with running a business, but there are an equal number of ways to prepare for and manage them.
  9. Active Trading

    10 Steps To Building A Winning Trading Plan

    It's impossible to avoid disaster without trading rules - make sure you know how to devise them for yourself.
  10. Markets

    PEG Ratio Nails Down Value Stocks

    Learn how this simple calculation can help you determine a stock's earnings potential.
  1. Are secured personal loans better than unsecured loans?

    Secured loans are better for the borrower than unsecured loans because the loan terms are more agreeable. Often, the interest ... Read Full Answer >>
  2. Which mutual funds made money in 2008?

    Out of the 2,800 mutual funds that Morningstar, Inc., the leading provider of independent investment research in North America, ... Read Full Answer >>
  3. Can hedge fund returns be replicated?

    You can replicate hedge fund returns to a degree but not perfectly. Most replication strategies underperform hedge funds ... Read Full Answer >>
  4. Does mutual fund manager tenure matter?

    Mutual fund investors have numerous items to consider when selecting a fund, including investment style, sector focus, operating ... Read Full Answer >>
  5. Why do financial advisors dislike target-date funds?

    Financial advisors dislike target-date funds because these funds tend to charge high fees and have limited histories. It ... Read Full Answer >>
  6. What does low working capital say about a company's financial prospects?

    When a company has low working capital, it can mean one of two things. In most cases, low working capital means the business ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Black Friday

    1. A day of stock market catastrophe. Originally, September 24, 1869, was deemed Black Friday. The crash was sparked by gold ...
  2. Turkey

    Slang for an investment that yields disappointing results or turns out worse than expected. Failed business deals, securities ...
  3. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
  4. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...
  5. Black Tuesday

    October 29, 1929, when the DJIA fell 12% - one of the largest one-day drops in stock market history. More than 16 million ...
  6. Black Monday

    October 19, 1987, when the Dow Jones Industrial Average (DJIA) lost almost 22% in a single day. That event marked the beginning ...
Trading Center