Musings on Performance – Benchmarking (Part 1)

In this 4-part series, I would like to address some issues and misconceptions regarding evaluating equity portfolio performance.  The first question is, how do you know if your portfolio is performing well (or not)?

The widely acceptable practice in the industry is to compare your portfolio performance to a relevant industry benchmark.  For example, a well diversified portfolio can be compared to performance of S&P 500 index.  Many other indices exist, tailored to specific industries, geographic regions, company sizes, etc.  But for simplicity we’ll accept S&P 500 as a benchmark.

Here’s a case study.  An investment portfolio that I manage for clients beat S&P 500 index by 3 percentage points annually, since its inception 8 years ago.  From the first glance, a few percentage points per year certainly doesn’t seem exciting.  I certainly thought so at the beginning of my investing career.  I didn’t want 3 percentage points, I wanted 30 points of out-performance!

It took me many years to realize that simply beating the index is, in fact, a very respectable goal.  Depending on who you ask, 70% to 90% of all fund managers actually underperform the index!  And this is not due to the fact that these managers are not competent or corrupt; it is because out-performing S&P 500 is actually very hard.  If you think about it, all the mutual funds taken together are the market, and so it stands to reason that an average manager will match the performance of the index.  However, managers have expenses — trading costs, administrative costs, and, of course, management fees — and so the net performance of this average manager drops below the index.

So in my case, I am quite happy with 3% out-performance.  But don’t take my word for it.  Ask any financial industry specialist — fund manager, wealth manager, financial planner — what he or she thinks about consistently beating the market by a “few” percentage points.

So, set your expectations accordingly.  30% of out-performance is not going to happen, even if you are Peter Lynch or Warren Buffett.