The Art and Science of Performance Benchmarking

For the past two decades, I’ve measured portfolio performance against benchmarks for individuals and institutions. None of us can control markets, but it’s critical that our clients know how they have performed relative to appropriate benchmarks.

Though that sounds very simple, it isn’t. I’ll explain why and then offer some suggestions on how to do this for your clients.

The benchmarking game

Let’s start with an example other than investments. Like 88% of drivers, I think I’m above average. You may have heard of the “Lake Wobegon” effect – the human tendency to overestimate ourselves. One reason we can fool ourselves that we’re all above average is by using different standards. I think I’m an excellent driver because my benchmark is saving time, getting from point A to point B quickly without endangering others or getting a ticket. My wife’s standard is getting from point A to point B while following all laws, including the speed limit. My benchmark may be wrong but, being only human, I’m unlikely to ever admit it.

The same goes for benchmarking investment performance. Here’s an example. A recent Barron’s article highlighted a study from Bank of America on the failure of the $3.27 trillion invested in target-date funds. The article stated:

2040 target-date funds’ performance has been lackluster, while offering minimal protection against volatility and declines than other options. Over the past 28 years, the funds – meant for investors who plan to retire in 2040 – returned a total of 750%, underperforming the 1,494% logged by the S&P 500 and even the 866% logged by a balanced 60% stock/40% bond allocation.

Not only have 2040 target-date funds lagged the index by a compounded annual average 2.4 percentage points, but they have done so without less volatility – 13.6% compared with 14.9% for the S&P 500 since March 1994, according to BofA.