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 MAY / JUNE 2017 41 © 2017 Investment Management Consultants Association Inc. Reprinted with permission. All rights reserved. FEATURE | The GOOD, The BAD, and The UGLY 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.