The Good, the Bad, and the Ugly

MARKET INDEXES AS BENCHMARKS The Good, the Bad, and the Ugly

By Jeremy Wadsworth

he first stock market index was cre- The Good 1. Indexes do not incorporate transaction ated in 1896 by Charles H. Dow. That The use of market indexes as the investor’s costs, expense ratios, or tax T market index, which he aptly named primary benchmark has had several signifi- consequences. the Dow Jones Industrial Average (DJIA), cant, positive influences on the investment 2. Indexes shift the focus to security selec- was an average of the top 12 stocks in the industry. Benchmarking against an index is tion rather than asset allocation. market. Over the next few decades, other simple to execute, easy to comprehend, and 3. Many asset classes have several companies began developing alternative creates a quantifiable goal for a manager. accepted indexes that have varying risk indexes and mechanisms that could mea- These traits have simplified investing for the and return characteristics. sure the movement of the overall market. general population. By increasing under- 4. Indexes may not focus or align with a In 1946, the S&P 500 as we know it today standing and clarity regarding the markets, client’s specific goals. was published. These indexes helped bring indexes have given individuals the confi- 5. Managing to an index may lead to poor transparency and a better understanding dence to put their hard-earned dollars to long-term performance. of the markets to investors. An unforeseen work in the market. Indexes have devel- consequence at the time, however, was the oped transparency for the average investor Indexes Do Not Incorporate influence indexes eventually would have as well as the media, making investing and Transaction Costs, Expense on the investor’s decision-making process. the markets part of everyday life. Ratios, or Tax Consequences Market indexes such as DJIA and S&P 500 The S&P 500 may accurately estimate the have become mainstays of the investment Furthermore, market indexes have revolu- overall movement of the U.S. equity mar- industry. Today, almost every fund man- tionized the investment industry through ket, but investing directly in the S&P 500 at ager is compared to the most relevant investment products designed to track zero cost is impossible. Exchange-traded index, and almost every financial advisor is market indexes. These passive investments funds (ETFs) and mutual funds have compared to the performance of the overall track the performance of a given market expense ratios, transaction costs, and bid- market. But a clear distinction must be index at a very low cost to investors— ask spreads (for ETFs) that the investor made between an index and a benchmark. sometimes as low as only a few basis points, must pay. Therefore, if a market index is An index is a group of securities gathered allowing investors to gain exposure to an technically unachievable, does it make together to provide a measure of a market. asset class at virtually no cost. This innova- sense to compare a manager to it? If the A benchmark, though, is a tool used to tion has had widespread effects, especially goal of a manager is to beat a benchmark, judge the relative performance of a stock/ in recent years, because active managers shouldn’t the benchmark be a realistic manager/advisor. Market indexes have have been forced to justify the higher fees investable alternative? Shouldn’t the bench- become the industry’s unrivaled bench- associated with their products. Margin mark represent a viable option if the inves- mark. Many advisors accept indexes as a pressure has occurred across the industry tor chose to invest alone, without the natural part of the industry and their work, and fees have been lowered almost univer- manager? but these man-made yardsticks need to be sally, certainly an advantage for investors. thoughtfully understood. This article pro- These benefits cannot be undervalued and This may seem trivial, but additional exam- vides a framework that can help advisors have transformed the investment industry ination illuminates the conundrum. Instead think about indexes and benchmarks and in a positive manner. of using the S&P 500, consider using an explain them to clients. The rise in promi- S&P index fund as a benchmark. Index nence of market indexes has been accom- The Bad funds are readily investable options, often panied by many influential and largely Market indexes have brought big-picture have no transaction fees on some custodial unintended consequences—some of them benefits to the investment industry, but they platforms, and typically have extremely low good, some of them bad, and some of them make poor benchmarks for the following expense ratios. Comparing a fund manager rather ugly. reasons: to an S&P index fund would largely result

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in the same conclusions as if one compared pre-tax basis. On an after-tax basis, how- due to larger allocations to international the fund manager to the S&P 500. However, ever, the PIMCO fund underperformed the equities and real estate, both of which pro- this story does not work for all asset classes. Vanguard fund by 0.8 percent. The tax effi- duced stronger returns than U.S. equities. Commodities, for instance, do not have a ciency of the Vanguard fund made it a bet- As seen here, the allocation decision played fund that closely tracks an accepted index ter option in a taxable account despite the a much larger role in the investor’s final for an extremely low cost. For example, the reported lower return. For any investor who return than the over/underperformance DFA Commodity Strategy is the cheapest is purchasing real estate in a taxable account, within an individual asset class. commodity fund available (expense ratio of comparing the after-tax returns is essential. 0.34 percent) and is one of the most index- Market indexes do not take into consider- This example does not make the case for like funds an investor can find in the com- ation any tax consequences, so a reasonable passive management; outperformance of a modity space. In this case, there is a higher comparison is difficult. benchmark within an asset class certainly possibility that a fund manager may under- adds long-term value. This example shows perform the Bloomberg Commodity Index, Indexes Shift the Focus to how asset allocation can have a greater the most widely accepted commodity Security Selection Rather effect than specific manager performance index, but outperform the DFA fund, a Than Asset Allocation on long-term returns. Across the industry, realistic investable alternative. Put simply, Using market indexes as benchmarks for significant resources and time spent with a pure index does not represent a genuine financial advisors is also problematic. An clients are focused on benchmark-oriented comparison. unfortunate side effect of comparing a returns within an asset class, and less atten- financial advisor’s performance to a bench- tion is placed on asset allocation. By focus- Additionally, indexes do not incorporate mark is the emphasis on security selection ing on benchmark-relative returns, the any tax consequences. For U.S. equities, one versus asset allocation. A U.S. equity fund investment industry may have its priorities could use a passively managed ETF, which that returns 11 percent when the S&P 500 backward when allocating time and rarely distributes capital gains or income, as returns 10 percent may make an investor resources. a benchmark rather than the S&P 500, and happy, but the allocation between various including tax consequences would not asset classes has a potentially bigger effect One way to emphasize asset allocation make a substantive difference. Other asset on this investor’s overall return. decisions may be to select a diversified classes, however, are not as tax-efficient. portfolio or fund as a benchmark when Within real estate, for example, there can be Table 2 shows that Investor A outper- evaluating financial advisors. Several exam- a large discrepancy between the pre-tax formed Investor B in every single asset ples fit this profile, including the Vanguard return for a fund and the after-tax return class. But Investor B outperformed LifeStrategy funds, the BlackRock Target for a fund. Investor A on a total portfolio basis due to Allocation funds, and the Fidelity Asset asset allocation decisions. Many people Manager funds. These funds typically invest For example, table 1 shows that the PIMCO would not question the allocation differ- in U.S. bonds, international bonds, U.S. Real Estate Real Return fund outperformed ence between Investor A and Investor B equities, and international equities through the Vanguard REIT Index fund by because both have a 30-percent allocation low-cost passively managed vehicles. 3.2 percent over the past 10 years on a to fixed income. The outperformance was Utilizing one of these funds as the primary benchmark would bring the allocation Table 1: 10-Year Return, Real Estate decisions made by the advisor to the fore- front of the conversation. An advisor who Fund Name Pre-Tax Return After-Tax Return is developing model portfolios for clients PIMCO Real Estate Real Return Strategy I 8.3% 3.0% would be judged more accurately against Vanguard REIT Index Fund Investor 5.1% 3.8% one of these funds (assuming equal levels of

Note: Return data ending December 31, 2016 risk) rather than by being measured asset class by asset class.

Table 2: Asset Allocation Many Asset Classes Have Allocation Return Several Accepted Indexes Asset Class A B A B That Have Varying Risk and Fixed Income 30% 30% 6% 5% Return Characteristics U.S. Equities 40% 25% 11% 10% There are now more than 40,000 approved International Equities 20% 30% 21% 20% indexes in the investment world today, per Zephyr StyleAdvisor. Of course, many of Real Estate 10% 15% 16% 15% these indexes are sector-specific, country- 12.0% 12.3% specific, or country-and-sector specific.

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Regardless, the sheer number of indexes Table 3: Comparison of REIT Indexes presents a problem. How does an investor choose an index to compare against a man- 1 Year 2 Year 3 Year 5 Year 10 Year ager? U.S. real estate investment trusts Dow Jones US Select Real 6.7% 5.6% 13.7% 11.8% 4.5% (REIT), for instance, have several globally Estate Securities accepted indexes that can produce very dif- Dow Jones US Select REIT 6.7% 5.6% 13.7% 11.8% 4.6% ferent comparisons, as shown in table 3. S&P United States REIT 8.5% 5.5% 13.2% 11.9% 4.9% MSCI US REIT 8.6% 5.5% 13.2% 11.9% 5.0%

A quick comparison of the two largest U.S. Note: Return data ending 12/31/2016 REIT mutual funds, Vanguard REIT Index and DFA Real Estate Securities Portfolio, highlights the disparity among the returns Table 4: One-Year Returns for these indexes. Together, these funds Fund Benchmark Out- have approximately $69 billion under man- Fund Benchmark Return Return performance MSCI US agement and account for roughly 52 percent Vanguard REIT Index 8.5% 8.6% –0.1% REIT of the entire U.S. REIT mutual fund indus- DFA Real Estate DJ US try. Despite their prominence, they utilize 8.4% 6.7% 1.7% Securities Portfolio Select REIT different benchmarks. The Vanguard fund compares itself to the MSCI US REIT index, Note: Return data ending 12/31/2016 and the DFA fund makes use of the DJ US Select REIT index (see table 4). The energy and resources put into beating goals of a client? By tracking an index, a benchmark detract from the most investors are inadvertently subject to the An investor comparing each fund to its important factor—how is the client doing decisions made by this committee. benchmark may conclude that the DFA in relation to the goal? Is the client earning fund was earning much stronger returns a high enough rate of return? Does the Since 1965, 22 companies have been added than the Vanguard fund, when in fact, the client need to take on more risk? Less risk? or removed from the index each year on Vanguard fund had outperformed the DFA Decrease spending? Can the client increase average. Millions of investors who are fund. This issue is not confined to obscure spending? These are the questions and focused on index returns experience alter- asset classes or small funds; this is occur- conversations that matter to the client and ations to their portfolios that do not reflect ring in well-accepted asset classes with the will have a greater effect on the client’s life, any changes in their individual situations largest mutual fund offerings available. This and advisors should be taking it upon or portfolio needs. lack of continuity can make investment themselves to focus on these issues. The decisions extremely difficult for individuals. client-advisor relationship is built on trust, Managing to an Index May Lead It is not a question of merit—both indexes and the client will concentrate on the top- to Poor Long-Term Performance accurately represent the U.S. REIT market. ics that the advisor brings up at meetings. Fixation on benchmark comparisons has led By selecting a realistic investable option as The conversation between the advisor and fund managers and financial advisors to the benchmark, investors and advisors alike client should address the client’s saving become very sensitive to tracking error. This can mitigate this issue. rate, for example, and not necessarily how is not necessarily the manager or advisor’s the client’s international equity fund per- fault; there is substantial business risk of los- Indexes May Not Focus or Align formed against the MSCI EAFE. Clients ing clients if returns vary significantly from with a Client’s Specific Goals take cues from their advisors regarding the benchmark. However, this in turn forces Attempting to ensure top-percentile returns, what is important. If advisors place more managers to prioritize, or at least seriously investors tend to focus on benchmark com- emphasis on the big-picture conversations, consider, the portfolio’s risk exposures rela- parison returns. This can cause investors to clients will follow. The result will be a more tive to the designated benchmark risk expo- lose focus on why they are invested in the optimal long-term plan to ensure that sures. A portfolio manager may decide to first place—to achieve specific, personal clients are achieving their goals. alter the portfolio to ensure a minimal level goals. Whether it is to save enough for of tracking error as opposed to an optimal retirement, leave an estate for heirs, preserve Along these lines, it is worth noting the risk-return profile. These decisions, when capital, achieve high growth, or some combi- manner in which indexes are constructed aggregated across all fund managers, likely nation of the above, each investor has an and reformulated. The 500 stocks in the diminish long-term performance for inves- explicit goal in mind. Beating a benchmark S&P 500, for instance, are selected by the tors. Some academic studies have shown return by 0.5 percent, for instance, is mean- S&P Index Committee, a team of analysts that mutual funds that exhibit greater style ingless if the absolute return or volatility is and economists. How are the decisions drift, which occurs when a manager moves sabotaging the defined goal. made by this committee relevant to the between different Morningstar style box

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classifications, earn excess returns compared The Ugly Conclusion with counterparts that are constricted to a Few people like to talk about or even The effects stemming from the ever- style box.1 Many funds are forced to stay acknowledge the ugly side of the industry’s increasing presence of market indexes within a style box due to pressure from reliance upon market index benchmarks— within the investment industry have pro- investors and advisors alike. These funds are the opportunity they provide for financial duced conflicting results. Market indexes punished by a loss of assets under manage- advisors and fund managers to manipulate have brought greater systemic understand- ment if they stray too far from the desig- client interactions by retroactively selecting to a largely cloudy world and have low- nated benchmark. Funds that are not ing benchmarks that create the appearance ered the cost of investing for millions. But beholden to a benchmark or an arbitrarily of strong portfolio performance. Outside advisors should not be so quick to accept constructed style box are more likely to pro- of U.S. equities and the S&P 500, a small market indexes as defaults for benchmarks. duce stronger long-term returns. minority of clients and investors track The use of market index benchmarks is markets such as international equities, laden with the potential for unintended con- A financial advisor may select a fund emerging markets, and real estate, and they sequences. Advisors with greater under- option because the advisor is confident the rarely know which market index to follow. standing of the issues surrounding the use of fund will move in sync with the designated A lack of knowledge on the investor’s part market indexes as benchmarks will promote benchmark even though the advisor may paired with the flaws of market indexes discussions with clients and advance trans- believe there is an alternative option that create an opening for advisors to poten- parency within the investment world. would provide stronger returns over the tially manipulate performance measures long term. Client behavior and business to enhance the appearance of their work. Jeremy Wadsworth is a senior financial risk could dictate that the advisor will make The U.S. Securities and Exchange analyst with Landmark Wealth Management the suboptimal decision. Removing the Commission requires fund managers in Amherst, New York. He earned a BA in concentration on index comparisons would to include in their annual reports com economics from Carleton College. Contact reduce pressure on fund managers and parisons of their performance to an him at [email protected]. advisors to closely resemble the return pat- “appropriate broad-based” securities tern of an index. Managers would be able to benchmark.2 This is vague language at best Endnotes 1. See for example, Russ Wermers, “Matter of Style: spend more resources on developing portfo- and does not prohibit a fund manager The Causes and Consequences of Style Drift in lios that align with their investment theses from switching the benchmark when it Institutional Portfolios” (March 15, 2012), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2024259. (i.e., value, growth, momentum, etc.) with- suits the fund. The lack of clarity and 2. U.S. Securities and Exchange Commission, “Final out concern for an arbitrary benchmark understanding regarding benchmarks, Rule: Shareholder Reports and Quarterly Portfolio Disclosure of Registered Management Investment return. This may lead to stronger long-term even among advisors, creates avenues for Companies” (effective May 10, 2004), https://www. returns despite any higher tracking error. potential abuse. sec.gov/rules/final/33-8393.htm.

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