Are Benchmarks the Right Measure of Investment Manager Success?

Benchmarks. Some people view them as a critical tool while others view them as a necessary evil. Used as a gauge, they can help to measure returns of a particular security, strategy or an entire portfolio to determine how it performed.

First, it is important to understand the benchmark being used. Typically, a benchmark is an index created by an index firm (S&P, Russell, MSCI, etc.). What is the composition of that benchmark? Is it a good representation of what you are attempting to measure? You should know the similarities and differences between the benchmark and your manager’s selections. Since it is a proxy, the benchmark chosen should be representative of what you are trying to achieve (or more than likely, exceed) in order to make a fair or appropriate comparison.

I review mutual fund managers performance on a regular basis and it is natural to look at how each manager did compared to their respective benchmark. For most, this is a logical and well-known way to determine the manager’s value. While this is something that I monitor, I am also paying attention to a variety of other factors including the manager’s returns and overall performance relative to their peer group.

A peer group consists of a defined set of “like” managers (both passive and active). The peer group ranking identifies how each manager stacks up against all others within that group. Rankings are broken up in percentiles, so 1-100, with 1 being in the top 1% of managers and 100 being the very bottom. Important to note here that this comparison has nothing to do with a benchmark.

So why did I start out talking about benchmarks, but now am looking at peer rankings which have nothing to do with a defined benchmark? Good question. Think of the peer group as an opportunity set. These are the managers to choose from for investment and I want to find the “best” manager among the available options.

Let me try to illustrate with an example. Let’s say the S&P 500 return was 10% and our large cap fund manager returned 9.5%. Across the peer group, this was the highest return. Simply measuring against the benchmark, the manager appears to have underperformed. When comparing against its peer group, however, this manager is at the top of the list. So, while they underperformed the benchmark, relative to peers they are the best choice available and outperformed the other options.

This may be an extreme example, but I hope it highlights that comparing a manager’s returns strictly against a benchmark is not the only measure of manager performance that should be used to make hire or fire decisions.

 

Washington Trust Bank believes that the information used in this study was obtained from reliable sources, but we do not guarantee its accuracy. Neither the information nor any opinion expressed constitutes a solicitation for business or a recommendation of the purchase or sale of securities or commodities.

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