Purpose
Benchmarking is a way of life. Babies are benchmarked to national averages and assigned percentiles for height and weight. Children are graded and sorted based on the academic standards they meet relative to peers. Teenagers compete to exceed an overly complex and mostly unknown admission benchmark of a coveted university. And for many adults, annual job reviews benchmark one’s performance against peers and goals as they compete for more rewarding careers. There is no shortage of benchmarks, they are embedded in our lives.
Your investment portfolio is no different. If you have an investment advisor, they provide you with portfolio, benchmark and peer group returns one, two, four, even twelve times a year. Is this healthy? Not necessarily. Does focusing on short-term results lead to better investment outcomes? Not likely. Should we reset our expectations and approach our performance reports with a different mindset? Yes, but it is hard and requires some rewiring. There is a hierarchy of benchmarks, and we often lose sight of the one at the peak of the pyramid – goal accomplishment.
It can be risky to your health.
Just as spending to keep up with the Joneses can bankrupt an otherwise financially healthy family, reacting to relative performance month in and month out can put an otherwise on-track portfolio into a tailspin. Note, index-only investors have little to worry about here, they have resigned themselves to accepting benchmark-like returns. This paper addresses investors who use active managers or a mix of active and passive managers.
Loss aversion is preferring to avoid losses rather than acquiring equivalent gains. Daniel Kahneman and Amos Tversky were credited for this theory in 1979, with Kahneman eventually winning a Nobel Prize in 2002 for their work in applying psychological insights to economic theory. They are the fathers of a powerful field of study – behavioral finance. Part of their work has shown that losses are twice as powerful, psychologically, as gains. Losing to a benchmark can have up to double the impact of winning versus a benchmark by the same amount. Why do we share this discovery? Because, at some points in time, all active managers underperform. Because great active managers sometimes underperform their benchmarks significantly. Obsessing over monthly returns can make you wonder why your portfolio has so many “losers” strewn about. Well, what about when they win? It is easy to forget about winning because bouts of losing hurt so badly. Do you see where this is headed?
Batter up.
Investment analysts cringe when they hear the term “batting average”. A batting average is the number of times a manager outperforms its benchmark over a number of equal length time periods. Professionals know that it must be handled with caution since it is such a simple metric. It ignores the magnitudes of wins and losses as well as the risk taken to achieve those results. If my batting average is 40%, but I outperformed by huge margins and only underperformed by tiny margins, my batting average will not reflect my success. However, the simplicity of a batting average outweighs its shortcomings for our purposes.
We have long held the belief that a 30-day performance comparison is random, half the time you win, half you do not. In fact, we would argue that a 90-day, 1-year, and even 3-year return streams are closer to random than not. Skill is not determined over one 3-year sample. We know that, but we often see scoring systems that heavily weight recent performance to “boil it down” to a single number that is actionable. Portfolio management does not work that way – believing it does can create a false sense of confidence.
To test our “even the greats have random short-term performance” hypothesis, we surveyed a Morningstar universe of active managers as of December 31, 2023, filtered out the more esoteric categories and focused on stock managers in traditional style boxes, such as large cap value or small cap growth.¹ We then computed monthly batting averages based on category and 15-year total return ranking by decile. The results are below.
Impressive? Hardly. The highest performing managers only managed to exceed their benchmarks about 55% of the time. The difference in batting averages between a top and bottom decile manager is strikingly small, yet return spreads, in large growth for example, are on average more than 5% per year for fifteen years. That is a cumulative spread of more than 100%. Top performing managers can build a tremendous long-term track record on what some might perceive as mediocre short-term performance.
Can you handle it?
If a manager wins 55% of the time, they lose the other 45%. Can you handle disappointment 45% of the time? It is not easy. We all know that monthly performance begets quarterly, annually, and so on. Imagine three months of losing to a benchmark, then seeing that the manager also missed its benchmark for the quarter. By definition, this must be true, but guess what? Those are four punches that hurt twice as much as when your manager outperforms each month. Remember loss aversion? Might you question why you are paying active management fees for underperformance? Maybe not outright, but a seed of doubt has probably been planted that next month’s result might only start to change. Psychologically, it can be hard to handle. It is possible to judge the outcomes of your portfolio too often. It is human nature to get manager fatigue from a return stream that is no different from a great manager, simply by measuring them too often. And our sample is top decile managers in their peer groups, A 55% batting average is the best you are going to get.
What to do then?
Upon realizing that humans are programmed to fail, we ask ourselves, what can I do? We propose three methods of overcoming our weakness.
1. Index a portion of the portfolio. Indexation costs are extremely low, and you will never be greatly surprised by the outcome – always a few basis points below benchmark. Even when other parts of your portfolio are lagging, you have a fund that holds a bit of everything. We believe passive management is also a great choice for efficient areas of the market. While not exciting cocktail chatter, using some passive management is a wise decision for many investors.
2. Dive deep into long term, shallow into short. Short term numbers have very little meaning whereas long term performance, statistical measures, and portfolio characteristics do. Are portfolio characteristics consistent relative to peers over long periods of time? Has a strategy performed as expected during volatile markets? If portfolio management duties transitioned, did the portfolio strategy change?
3. Be patient and have faith in the investment process. Knee jerk reactions to short term blips are normal but can be combatted. Your investment consultant is part market wizard but also more psychologist than you may think. Making portfolio adjustments that seem uncomfortable at the time usually means they are doing something right. And remember, just like a money manager there will be wrong decisions. Nobody can perfectly predict the future and even if they could, investing in it would remain difficult.
The Perfect Benchmark is…
Humans love to benchmark. Afterall, we have been engaged in benchmarking since birth. We would never recommend abandoning benchmarks and leaving your portfolio unmonitored. A proper portfolio is managed to your risk and return profile with an eye towards your investment horizon. We need benchmarks and a healthy dose of perspective to measure our portfolios and make sure we remain on track. They help investors see trends and course correct, when necessary. However, we would argue that the perfect benchmark has no stocks or bonds in it at all. Instead, the perfect benchmark is whether your financial assets achieve the goal for which they are intended. Are you able to comfortably retire? Is your foundation able to effectively support the mission of your organization? Can grandchildren emerge from college without a heavy debt burden? Will an endowment enrich the lives of many for decades to come? Are you properly invested to meet the needs of today and the goals of tomorrow? These are the benchmarks, the real-life portfolio impacts, that we strive to realize over the course of a portfolio’s life.
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Investment Advisory Services are offered through Cornerstone Advisors Asset Management, LLC.
Cornerstone Advisors Asset Management, LLC and Cornerstone Institutional Investors, LLC are independently owned and operated. Cornerstone Institutional Investors, LLC is a member of M Financial Group. Please go to mfin.com/Disclosure for further details regarding this relationship. For important information related to M Securities, refer to the M Securities’ Client Relationship Summary (Form CRS) by navigating to mfin.com/m-securities. This document is for information purposes and should not be construed as legal or tax advice and is not intended to replace the advice of a qualified attorney, financial or tax advisor or plan provider. 6509391.1
