Benchmarking is a pernicious thing in financial circles. Not only because it disconnects the way the client and a fund manager understand the concept of “risk”, but also because the concept of benchmarking seems to be misunderstood. For instance, if you turn on the evening news these days you inevitably see the intra-day return of the S&P 500 or worse, the Dow Industrials. But equities account for only about 15% of household net worth. And the Dow, the most widely cited index, is just a small sliver of this 15%. Bond markets, on the other hand, are magnitudes larger than stock markets, yet it’s hard to find any mention of bond price changes. Yet this “benchmark” of our daily market performance is thrown in our face on a daily basis.
This is not to say that the state of equities and corporate America isn’t extremely important, but I do wonder if we don’t focus too obsessively on this “benchmark”. Even worse than this daily phenomenon is the obsession with comparing every asset class to the S&P 500. Following a year like 2013 when the S&P 500 generates a 32% return, we inevitably see countless articles about how this or that index “underperformed”. For instance, hedge funds have been raked over the coals in the last 2 months following their performance in 2013. But “hedge funds” are nothing like the S&P 500. In fact, if you look at the HFRX indices on their website, you’ll find countless different types of strategies that do nothing even remotely close to what the long only S&P 500 does. Yet we continually see these apples to oranges comparisons.
But it gets worse. Often times, these comparisons are made without even considering the right way to quantify “risk”. That is, we don’t even see measurements of risk adjusted returns in these “performance” reviews. Of course, that misses the whole point of implementing a strategy that is different than a long only index.
It’s fine to compare things to a benchmark. In fact, it’s helpful in a lot of cases. But we need to careful about how we go about doing it.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.