Comparing a portfolio’s returns to the returns of an arbitrary benchmark of stocks, bonds and the like, has been an “Old Institution” tradition since the index was first created, writes Landon Whaley, who is presenting at MoneyShow Orlando Feb. 9.
This week I’d like to coddiwomple through the age-old practice of “benchmarking” and how this “Old Institution” concept is hurting investors ability to generate returns.
Comparing a portfolio’s returns to the returns of an arbitrary benchmark of stocks, bonds and the like, has been an Old Institution tradition since the index was first created, but it’s an incredibly ineffective way to determine if an asset manager has skill or is just riding the fact that markets naturally drift higher over time. But we’ll save that discussion for another day, because this week I want to coddiwomple through the fact that this benchmarking concept has made its way to the individual investor in a big way and is doing investors a great disservice.
Everyone and their mother are comparing their returns to that of an index like the S&P 500, or to an index portfolio like the traditional 60/40 benchmark mix of stocks and bonds to ascertain if they should be happy or sad with the returns they earned. (Even alternative strategies are being compared against specific benchmarks to define what constitute true alpha vs. beta returns).
Who cares how your portfolio did against the S&P or a 60/40 mix of U.S. stocks and bonds? Are you ever going to have 100% of your portfolio in U.S. mega-cap stocks? I certainly hope not, so get rid of the S&P comparisons. Are you ever going to statistically allocate 60% of your portfolio to U.S. mega cap stocks and the other 40% to U.S. bonds? If you believe (and you should) that the prevailing fundamental gravity drives the risk and return of asset classes, then your answer is a resounding no.
There are times to be invested in certain asset classes and times to steer clear of them, which makes this “relative to an index” performance game a non-starter. There is only one way to evaluate your portfolio’s returns: net absolute returns. Net means the returns you’ve earned after all commissions, fees, taxes and the like. Absolute means that regardless of market conditions, did you earn a positive rate of return?
For example, with your 2018 portfolio returns, there is only one question that needs answering: did you make money after all fees and taxes?
“But Landon, you told me that last year was the worst year for global financial markets since the 1970s and that 90% of asset classes globally were negative for the year. How can I earn absolute returns in that kind of environment?”
I’ve been professionally managing money for 19 years, and I can personally attest that if you have a dynamic, multi-factor process, positive net returns are yours to be had each year.
Despite most financial markets being underwater last year, the Gravitational 15 clipped +14.9%. While I acknowledge that a big chunk of that return came from the short side, our long positions generated a net return of +4.46%. You may be thinking that’s a puny return, but I can promise that most investors who had capital at risk last year, individual or professional, would trade their 2018 return for 4.5% in a heartbeat.
Even with a process that is built with a focus on net absolute returns, the yearly returns will be driven by the opportunity set that your process identifies, so in some years you’ll hit singles and in others you’ll crush double-digits.
Leave benchmarking to the Old Institution and its followers. Building an absolute return process is the only way you can keep the “Hi, welcome to Walmart” risk at bay.
