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. Mutual Funds & ETFs

    Top 3 PIMCO Funds for Retirement Diversification in 2016

    Explore analyses of the top three PIMCO funds for 2016 and learn how these funds can be used to create a diversified retirement portfolio.
  2. Mutual Funds & ETFs

    The 4 Best Lord Abbett Mutual Funds

    Discover the four best mutual funds administered and managed by Lord, Abbett & Co., LLC that offer investors a wide variety of investment strategies.
  3. Mutual Funds & ETFs

    The ABCs of Mutual Fund Classes

    There are three main mutual fund classes, and each charges fees in a different way.
  4. Investing Basics

    10 Habits Of Successful Real Estate Investors

    Enjoying long-term success in real estate investing requires certain habits. Here are 10 that effective real estate investors share.
  5. Investing Basics

    5 Types of REITs And How To Invest In Them

    Real estate investment trusts are historically one of the best-performing asset classes around. There are many types of REITs available.
  6. Investing Basics

    5 Simple Ways To Invest In Real Estate

    There are many ways to invest in real estate. Here are five of the most popular.
  7. Fundamental Analysis

    5 Must-Have Metrics For Value Investors

    Focusing on certain fundamental metrics is the best way for value investors to cash in gains. Here are the most important metrics to know.
  8. Investing Basics

    5 Common Mistakes Young Investors Make

    Missteps are common whenever you’re learning something new. But in investing, missteps can have serious financial consequences.
  9. Stock Analysis

    Analyzing Baidu's Return on Equity (ROE) (BIDU)

    Find out how Baidu's return on equity (ROE) compares to industry peers and historical results. See how DuPont analysis treats net margin, asset turnover and leverage.
  10. Mutual Funds & ETFs

    The 4 Best American Funds for Growth Investors in 2016

    Discover four excellent growth funds from American Funds, one of the country's premier mutual fund families with a history of consistent returns.
RELATED FAQS
  1. What is the formula for calculating EBITDA?

    When analyzing financial fitness, corporate accountants and investors alike closely examine a company's financial statements ... Read Full Answer >>
  2. How do I calculate the P/E ratio of a company?

    The price-earnings ratio (P/E ratio) is a valuation measure that compares the level of stock prices to the level of corporate ... Read Full Answer >>
  3. How do you calculate return on equity (ROE)?

    Return on equity (ROE) is a ratio that provides investors insight into how efficiently a company (or more specifically, its ... Read Full Answer >>
  4. How do you calculate working capital?

    Working capital represents the difference between a firm’s current assets and current liabilities. The challenge can be determining ... Read Full Answer >>
  5. What is the formula for calculating the current ratio?

    The current ratio is a financial ratio that investors and analysts use to examine the liquidity of a company and its ability ... Read Full Answer >>
  6. What's the difference between a stop and a limit order?

    Different types of orders allow you to be more specific about how you'd like your broker to fulfill your trades. When you ... Read Full Answer >>
Hot Definitions
  1. Super Bowl Indicator

    An indicator based on the belief that a Super Bowl win for a team from the old AFL (AFC division) foretells a decline in ...
  2. Flight To Quality

    The action of investors moving their capital away from riskier investments to the safest possible investment vehicles. This ...
  3. Discouraged Worker

    A person who is eligible for employment and is able to work, but is currently unemployed and has not attempted to find employment ...
  4. Ponzimonium

    After Bernard Madoff's $65 billion Ponzi scheme was revealed, many new (smaller-scale) Ponzi schemers became exposed. Ponzimonium ...
  5. Quarterly Earnings Report

    A quarterly filing made by public companies to report their performance. Included in earnings reports are items such as net ...
Trading Center