by John R. Goltermann, CFA, CPA, CGMA
February 22, 2018
When you have worked in the investment advisory business for a long time, you cannot help but notice that an enormous number of firms publish their equity returns side by side with the returns of the S&P 500. I have always found this practice to be odd. To present one’s own returns next to the S&P suggests that the two are comparable somehow. And for the returns to be comparable, their portfolios must be comparable – in other words, the advisor must be fishing in the same pond as the S&P; otherwise the S&P is not relevant. So wouldn’t an investor be better off buying the S&P and paying virtually no fees instead of paying high fees to a firm that compares itself to the S&P?
The answer is yes.
Why do so many investment advisors compare their returns to the S&P? They do it because they know that clients view the S&P as a proxy for “the market” and hire and fire advisors based upon this performance difference. And if advisors happen to outperform the S&P over some arbitrary period of time, it makes them look smart. Almost every advisor has some period during which it has outperformed the S&P, but such a comparison speaks nothing of risk.
Advisors publish relative returns so that their clients and prospective clients believe that the comparison is important to the advisor. But if the comparison is important, doesn’t that mean de facto that the advisor is trying to “beat” the S&P for its investment goal? And if an advisor managed to beat the S&P, it must have taken more risk, because for those that focus on short-term outcomes returns do not come without risk – even relative returns. Clients of such firms should ask themselves a) if they want their advisor to take the risks needed to beat the S&P; b) whether such risks are appropriate; and c) whether a portfolio that is similar to the S&P is a good idea when the index itself trades at high valuations.
In fact, when advisors publish relative returns, they are telling you that this is how they measure their own success. And when they measure their own worth by whether they have beaten the S&P, it speaks volumes about that firm, its culture and its priorities. You, their client, may be well-advised to question such a firm’s incentives, its quality and whether to continue to do business with it.
1 ) Investment advisors that compare their returns to the S&P imply that their goal is to beat the S&P and that that should be your investment goal, too. But should it? It seems to be generally accepted that if an investment firm doesn’t beat the S&P on a consistent basis, then it is worthless because you can “buy” the S&P effectively for free (in fact, Charles Schwab & Co. has an index fund that assesses 3/100th of 1% annually). But what about risk? The S&P is simply a basket of stocks, mostly US-based companies, with little or no representation of other oft-great investments that also offer high returns – i.e., real estate, foreign stocks, private equity, commodities, currencies, etc. – but have different risks and patterns of return. Moreover, the S&P’s return is largely driven by 50 stocks. So, anyone who makes investments in assets that have different patterns of returns will, by definition, deviate from the S&P. And to deviate means that some years’ returns may lag or beat the S&P. This is not a bad thing and is completely independent of the quality or potential of the underlying investments. It is the average annual return and the level of risk taken (risk being the probability and amount of a permanent loss of capital) that should matter to investors!
2) Advisors that try to “beat the S&P” often have poor decision-making, a weak investment process and take too much risk. If an advisor is trying to beat an index, that means it is looking for its portfolio to rise more rapidly. How do you do that without taking more risk? Answer: You can’t. If one is trying to beat an index, it is likely that one would start with a portfolio much like the index itself and then make incremental bets to try to beat it – because significant deviation would be bad. This is especially true if clients are oriented to compare themselves to the S&P in the first place. What you will then get from that advisor is an S&P-like return. This is called “closet benchmarking,” and if advisors are doing it, their fees are too high.
The Wright brothers, in pursuing sustained flight of a powered aircraft, were well-advised to mostly ignore previous aircraft designs. They borrowed some of the designs from years past but focused on solving the problem of flight control. Had they used the designs from previous failed attempts, we might still not have airplanes. Any time the focus is on trying to predict near-term price movements instead of simply making a good investment through a diligent repeatable process (evaluating the quality of the underlying business and the value of the stock), poor decisions will be made.
3) The S&P’s fabulous return of the last nine years does not predict its future return, nor does it account for today’s inherent risk. Every investment has its own set of risks. While returns are observable, risks are not. It is important for S&P investors and closet benchmarkers to know that the S&P is risky because the top 50 stocks are responsible for half of the index’s return. The index is weighted by the size of the company, which means larger companies have larger weights.
A common measurement of a stock’s risk is the price-to-earnings (P/E) ratio. This is the price of the stock per unit of earnings (earnings per share) that the company produces – so the higher the P/E ratio, the more risk a stock might have. The historical average P/E ratio for the S&P is 15.7. The median P/E ratio for the top 50 stocks in the S&P index is 27. As you can see, there is quite a lot of risk currently in the S&P. And if your advisor is trying to beat the S&P (which is likely what they are trying to do if they are comparing their returns), I would be cautious with that advisor because it is likely that it is taking even more risk in an already risky portfolio with your hard-earned capital.
4) The characteristics of the S&P itself are arbitrary and can be risky. What is so magical about the S&P that makes it worthy of trying to beat? It is a measure of the price return of large-cap US stocks, but there are many other investments – and, since the S&P has quadrupled in the last nine years, most today likely have less risk.
Moreover, the S&P has its own unique and somewhat arbitrary sector weighting, which does not reflect anything other than the past performance of these sectors. For example, in 2000 after years of languishing, energy declined to 6% of the S&P and information technology climbed to over 30%. Over the next nine years, the energy sector returned positive 8.1% per annum on average and IT companies lost 12.4% per annum. Today, the S&P is 5% energy and 25% information technology. So is it a good idea to be overweighted technology and underweighted energy right now given what we know about the past? The goal of investing should be to make money with as little risk as possible – not beat some arbitrary benchmark. And to do so may require creating an investment portfolio that looks nothing like the S&P.
As index funds became popular and attracted assets in the late 1990s, it was difficult for active managers to beat the S&P return. Then by 2000 when the valuations of certain sectors were completely out of whack and they began to reweight themselves, the S&P became easy to beat for a ten-year period (2000-2010). Now for the last nine years, the S&P has become difficult to beat again as index and ETF investing have become extremely popular (see chart on the next page). But this is not likely to last forever as the top 50 stocks in the S&P are expensive (illustrated in #3 above), and it has an extreme overweight in information technology and underweight in energy and materials. And among those top 50 stocks, there are only two energy companies, so there is limited diversification.
And perhaps most importantly, because the S&P is a market-cap weighted index, the largest position in the portfolio is, by definition, the largest company and the 500th position is the smallest in size (as selected by S&P Global). That means that Apple’s weight in the portfolio is 353 times larger than Chesapeake Energy’s, in turn implying that it is a 353 times better investment. If this is true, why invest any money in Chesapeake Energy at all? And to add to the absurdity, by investing the largest chunk of your capital in the largest company, you make an implicit bet that the largest company is always the best investment (with the most upside, least risk, or both). This is simply not true. Cisco in the year 2000 was the largest company in the world and the largest weight in the S&P. A year and a half later its stock price was down 80% and stayed there for 10 years. The largest company in an index is rarely the best future investment, so it makes no sense for it to be the largest position in your portfolio.
5) Relative performance is a poor measurement of investing success or failure. Here is a thought experiment: If the S&P was down 37% (as it was in 2008), and an advisor constructed a portfolio that was down 25% instead of down 37%, did its clients have a good year? If an advisor constructed a portfolio that was up 20% when the S&P was up 30%, did the clients have a bad year? The point is that investing should be goal-oriented and done with a completely independent view of whatever the S&P does. Comparing returns detracts from this effort. Investing should always be done with the goal of earning the most return with a level of risk appropriate for the client. And when advisors compare their own returns to the S&P, they are implicitly saying that tracking toward the client’s goal is not important to them but tracking to the S&P is. The return of the S&P relative to other investments is also driven by preferences for “passive” investments, which goes in and out of favor.
A more appropriate goal for equity investors is a fixed return that is relevant to how much risk is assumed, and the level of that risk is relevant to you. However, because of the vagaries of markets, the ebb and flow of liquidity, interest rates, etc., equity returns will not occur in a straight line. An average annual return of 12% is a much better goal for equity investors and will be a better guide for the selection of investments. A 12% average annual return is appropriate for the risk inherent in most equities. But because of behavioral and emotional factors that drive markets, 12% must be earned over a long period for the advisor to have the freedom to invest properly. In terms of constructing a portfolio, a fixed benchmark incentivizes the advisor to avoid excessive risks because it is much easier to compound returns when the downside is kept as low as possible. This is the mathematics of returns: If a portfolio is down 33%, one needs a 50% return to break even. If a portfolio is down 50%, one needs a 100% return to break even. If an advisor’s goal is to simply beat the S&P, there is little incentive to avoid poor investments that are at risk of a permanent loss.
6) Owning good risks and eschewing bad risks is a better process than trying to “outperform.” In the investment universe, there are good risks and bad risks. The goal should be to own all good risks in your portfolio – and to avoid bad risks. And moreover, one should also have an appropriate amount of diversification (investments whose returns are driven by differing sources and scenarios) simply because the future is unknowable. One does not need 500 stocks to do this. Tracking the S&P with its 500 stocks (especially when the P/E ratio of the top 50 stocks is 27) means owning a lot of “bad” risks, but it also serves to reduce the incentive of advisors to genuinely understand their investments when they care very much about how their portfolios’ returns compare.
7) “Benchmark hugging” is silly when you can buy the S&P for free. Let’s face it: Most professional investors are benchmark huggers. Why? Because the prospect of lagging the S&P presents significant business risk (risk of losing clients) to the advisor. But ironically, it is the advisor’s job to take on business risk by being willing to deviate from the S&P with portfolios designed to reduce risk or earn more return. The cardinal rule for firms in the investment business is that it’s OK to be wrong with the crowd (being wrong when everyone else is wrong is forgivable), but never be wrong with a controversial or unpopular call. The reality, however, is that the crowd is wrong all the time – for evidence see every bubble in history. Loading up on tech stocks in the late 1990s was exactly the wrong call, but most advisors did it anyway for fear of missing out and they were forgiven by their clients. It is for this reason that most advisors seek safety in making their portfolios look like the S&P – clients do not fire them when they make the same huge mistakes as the crowd.
8) Fees should only be paid for active, well-researched investments and to advisors who are willing to deviate from the S&P and risk looking bad. Investment advisors should be hired for their investment philosophy, their experience and competence, a thorough, diligent and repeatable investment process and client advocacy. Advisors that are good investors should create portfolios that are more concentrated and have a higher “active share” than the S&P. If someone wants an S&P return, they should just go buy an index fund and skip hiring an advisor. If they want a different portfolio that might be more appropriate for their own financial goals, with perhaps less risk and/or better potential returns, they should hire a top advisor. But prospective clients are ill-advised to make inferences about the competence or process of an advisor from relative returns, and advisors should not hold out their returns as comparable unless their portfolios actually look similar to the S&P. Otherwise, the comparison is irrelevant and misleading.
9) Short-term market moves are random, and comparing returns speaks nothing about investment process; to imply that it does is deceptive. A great analysis and strong investment process are not rewarded immediately in stock prices. Advisors who focus on the very long term want to own assets that will perform well over long periods of time. Benjamin Graham famously said, “In the short run, the market is a voting machine, but in the long run it is a weighing machine”, meaning that substance eventually trumps sentiment. Relative returns of less than 10 years are meaningless.
Beating the S&P every period is impossible, so advisors should not try…they should just try to own great investments. If I (who shoots around 100 over 18 holes of golf) played a hole against three-time major winner Jordan Spieth and he parred the first hole and I shot a birdie, does that make me a better golfer? Does that predict that I will win an 18-hole round? The point is that comparison to the S&P is often meaningless, and even though clients may want to contextualize their performance, a comparison is not relevant over short periods of time and advisors should say so.
10) The act of publishing relative returns itself signals that an advisory firm’s clients may have undue influence on the investment process of the firm. Why would an advisor publish or present their returns in comparison to the S&P? I have asked many advisors this question and the answer is usually something like, “it is what the clients want to see,” or that clients want to know how their advisor is “doing” even if it is not a relevant comparison. But what information does this comparison actually convey? What if the advisor’s portfolio is half as risky or twice as risky as the S&P? Is it still a relevant comparison? Does the advisor speak about how they think about risk, or how much risk is in their portfolio? Advisors are in the business of giving advice, and if the S&P is not a relevant comparison, they should simply explain their investment philosophy and process to be transparent to their clients.
Even if some clients might want to see relative returns, it shouldn’t be pushed out to all clients to imply that it is relevant when it isn’t, or to suggest that the S&P return reflects risk that befits clients’ goals. The comparison is probably only relevant to US-only large-cap advisors, whose investment universe is similar to the S&P’s and who market-cap weight their portfolio. There are thousands of advisors who do this, including most bank trust departments, but many charge usurious fees and their clients would be well-advised to just buy the S&P and save the fees.
11) Following from #10, if your advisory firm’s clients fixate on relative performance, you are at a disadvantage. As an advisory client, you want your advisory firm’s other clients to be sophisticated and to understand and buy into what the advisor is doing. You can bet that if that firm compares its returns to the S&P, it will have many performance-chasing clients and the advisor will be hired and fired often. And if the firm has performance-chasing clients, during periods of stress or periods of underperformance (which come to every investment advisor), it will be under more stress to make its portfolio look like the S&P and make riskier investments and it will spend a lot of time explaining itself to clients. None of these are good for you.
12) There is no secret sauce to investing. Results and risk are the only things that matter. Comparative returns distract the clients’ focus from where it should be – their goals. The best an investor can do is take the time needed to thoroughly evaluate prospective investments, to understand the businesses and the quality of their assets, to know the rules of accounting and finance and to reach a decision. And that means not making huge, costly mistakes. Charlie Munger once said, “It is remarkable how much long-term advantage people like Warren [Buffett] and I have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.” What should matter most to advisory clients is how much the advisor knows about you, cares, is competent and how much it charges. Experience in investing through bull and bear markets, an ability to quell emotions and stay objective, and a willingness to deviate from the S&P (and to look bad occasionally) are what make for a good advisor.
What it all means:
It really comes down to incentives. If advisors feel incentivized to beat the S&P, that is what they will try to do. The simple act of publishing relative returns creates that incentive. If other advisors try to earn a 12% average return or better, they are likely to create a portfolio that looks very different from the S&P and has less risk, because to earn a 12% average return means avoiding significant downside in every investment.
The investment business is full of closet benchmark managers. Why pay someone to give you a portfolio that will mirror the S&P plus or minus a marginal amount? Save the fees! But it is always worth considering how much capital you want tied up in an S&P-like portfolio, and that comes back to valuation. If the S&P is cheap, own it; if it is expensive (like today), one may want to own less of it or none at all. Because index investing falls in and out of favor, sometimes the S&P is not the right thing to own.
The reality is that past returns are not predictive of future returns in any way…even relative returns. Famed investor Bill Miller beat the S&P 15 years in a row, then promptly gave back all of that cumulative outperformance in two years. Therefore, if you bought Bill Miller’s fund any time during those 15 years because of his outperformance, you would regret it. Relative returns convey no useful or predictive information, yet advisors continue to publish them.
The advisory industry is highly competitive. Success is measured by “assets under management” because more assets generate more revenue. Yet many firms are successful because they are superb at gathering assets through marketing and storytelling, and not so great at investing. And investing is what they get paid to do. It is important for you to know what value your advisor provides to earn its fees, how much risk it is taking and whether that risk is appropriate for you. It is far more important that your advisory firm is competent and consistent and knows you well then it is how they compare to the S&P. If your advisor compares its own return to the S&P, questions should be raised about that firm’s process and what the culture of the firm is like. The answers to those questions and the decision to continue to do business with that firm can make an enormous difference to your overall financial well-being. So, if your advisor compares its return to the S&P – ask yourself why and what it really means about them.
 Source: Standard and Poor’s