Outperformance Does Not Guarantee Cash In Your Pocket

There are, in short, hundreds of ways to measure performance.

The overwhelming attitude today is that, whether we invest in performing seals, monkeys, algorithms or fund managers, it doesn’t seem to matter diddly squat unless the strategy outperforms its benchmark.

And the benchmark can come in various forms – market capitalisation, low volatility, cash, inflation, equally weighted or sector average – but that shouldn’t matter to a large extent for a financial advisor. Now that commission is banned under the UK Retail Distribution Review, advisors have generally come to adopt a more holistic life and financial planning approach, which focuses on the clients’ objectives.

The questions have become different – when do you want to retire? How much income do you need? Are you saving for your son’s wedding or your daughter’s university fees? And what happens if your partner loses their job?

Suddenly, it doesn’t seem so important if your active fund manager has slipped from first to second quartile sector performance this month, or if your passive fund has increased its tracking error by 0.06 percent.

As retail investors, we are constantly struggling with short-termism and shiny marketing brochures, instead of focusing on saving for those rainy days.

But if you can’t fight it, roll with it.

There are some very important points to remember when measuring fund performance.

1. Fund providers and fund managers choose their benchmark. The fund might have outperformed the FTSE World over five years, but did it beat equivalent benchmarks from MSCI and S&P?

2. This argument also applies to measuring your investment against the sector average, which invariably is quite low. Remember, your fund may have survived the 2008 crash much better than its peers, but it might still have lost you money.

3. Research from S&P Dow Jones Indices this month said investors should ditch the low bar of market cap weighted indexes and bench active managers against equal weighted indexes, which rank index stocks in equal measure, to test whether the active manager is performing due to skill or luck.

4. Using cash as a benchmark for your income fund is not a high bar to set. The Bank of England’s base rate has been at a record low of 0.5 percent for some time now. Meanwhile, inflation might be eroding your returns. Ask yourself if your investment is beating inflation instead.

5. Look for performance net of fees. Always, always net of fees. Your Absolute Return fund has done well year to date, but minus the annual management charge of 1.75 percent and returns suddenly appear lacklustre. One indexer to publish performance results from discretionary fund managers (DFMs) net of fees is the Asset Risk Consultants Private Client Indices. But they only compare a select group of DFMs who signed up to the service. Nutmeg, the online, ETF specialist DFM, has also published consistently positive performance net of fees, and is one of the few asset managers to do so.

6. Avoid short-termism. How has your active or passive fund performed over three, five and ten years? Year to date might not tell you much.

7. But remember that past performance does not equate to future returns. The regulator says it, brochures say it, everyone says it. So why do people always get so excited about past performance?

8. Fund ratings do not tell the whole story, and every rating agency has its own criteria. Instead of getting over excited by an AA rating, find out how long the manager has held on to – and dropped – this title over the years.

One benchmark in recent headlines is the Global Investment Performance Standards (GIPS), the Chartered Financial Analyst Institute’s highest indicator of investment performance. It was most recently awarded to Rathbone Investment Management this month. To achieve this status, fund managers have to set up mirror portfolios and publish performance. This benchmark is certainly better than looking at the performance of one fund alone, which allows the manager to sneakily choose its best performer, and it is always good to compare like for like.

“Advisers should choose the most appropriate performance measure for their clients, and use it consistently and, of course, make sure that criteria other than past performance are part of their final selection process,” wrote Lawrence Cook, head of business development at Thesis Asset Management in a blog on 18 June.

But don’t get clouded over with AAs and “first quartile” and “outperformance”. None of these terms will impress your clients when you have to explain to them why they can no longer go to the Caribbean for their 20th wedding anniversary.

In fact, there are some asset managers that do not use any reference benchmark whatsoever. One is Heartwood Investment Management. This allows you to focus on real, positive returns, and not look for a top position in the league tables.

As Neil Rossiter, chartered financial planner at Blackdown Financial, puts it: “What point is there beating a benchmark if the client does not achieve their goals?”