SKARBECK: Benchmarks helpful, but have their problems

In the investment industry, benchmarks are widely used to measure and compare the results of active money managers. A benchmark is typically an index with a value based on a broad number of securities within a particular investment asset class.

In the United States, the Standard & Poor’s 500 index is the granddaddy of all benchmarks, covering the 500 largest publicly traded U.S. companies and weighted by company size. The performance of the largest companies have more influence on the index than the firms ranked 400th through 500th, for example. When used as a benchmark, the S&P 500 index is usually calculated with dividends reinvested since managed investment portfolios regularly receive and reinvest dividends.

Benchmarking has exploded with the industry’s propensity to slice and dice and categorize every segment of the overall investment pie. There are indexes that measure stocks, bonds, commodities, real estate, hedge funds, subprime mortgages—any investment category you can imagine.

The mutual fund research firm Morningstar developed a simple benchmarking system with their “style box” grid of large, medium and small companies grouped by a value, blend or growth investment style, thereby creating nine categories for mutual fund comparison.

The key argument for benchmarks is the notion that a money manager who focuses on, say, small-company foreign stocks, should not have his performance compared against the returns of the 500 largest U.S. companies—it’s apples to oranges. In this case, an index constructed on a broad universe of small-company foreign stocks is considered a better comparison.

While benchmarks are helpful to investors analyzing the long-term performance record of an investment manager, the concept has its problems. To begin with, it is sometimes unclear which benchmark to use. Should the manager be compared to a small-company growth index or is a midsize blend benchmark more representative?

In addition, once a benchmark is selected, it can effectively “pigeonhole” the investment manager. Say, for example, the manager’s benchmark is the Russell 2000 index, a popular index composed of 2,000 small companies. He may hesitate, or worse be prohibited, from buying a large company like Exxon—even if he believed the stock was an exceptional investment opportunity. This kind of constraint is prevalent in the institutional money management arena.

Also, some managers view their benchmark as their “bogey.” As such, they “hug” their benchmark and structure the portfolio to mimic the index under the belief that investors will be less likely to cash out if the performance is close to their stated benchmark goal. The manager’s fear of getting fired creates this phenomena, referred to as “closet indexing.” Naturally, if a manager isn’t beating his benchmark, or what is called “adding alpha” in the industry, his investors would be better off with a low-cost index fund that tracks the benchmark.

Last, benchmarks compare “relative” performance, but we live in an absolute world where future liabilities are paid with absolute, not relative, dollars. Consider that the Legg Mason Aggressive Growth Fund (-3 percent annually) has crushed its benchmark, the Russell 3000 Growth index (-8.6 percent annually) over the past 10 years. However, it is doubtful that Citizens Gas would take 3 percent off your bill in recognition that your investment in the fund beat its benchmark.•

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Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money management firm. His column appears every other week. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.