Avoid any fund manager that says this...

It's good advice to focus on your goals, but it could also be intentional misdirection. 

One of the cringiest moments I had on a flight to Vancouver recently was being locked into my seat, watching an ad for a Canadian fund manager.

"What really matters is reaching your long-term goals, not beating some benchmark," it said.

Pickpockets know that the easiest way to get to your wallet is when you're looking the other way - and any fund manager telling you that relative performance doesn't matter should instantly pique your scepticism.

For one, you can bet they don't beat the general market indexes, otherwise they'd be drawing your attention to their above-average performance. Long-term goals are important, but benchmarks are even more so when choosing a fund manager - without them, you're likely to pick a dud, which could limit your returns or expose you to unnecessary risks.

To explain the significance of benchmarks, there's no better teacher than the medical industry.

Before a drug reaches the shelves, it goes through a series of clinical trials to test its effectiveness. One feature often employed is the use of placebos, where participants are split into two groups, one of which gets the drug being tested and the other gets a fake alternative, such as sugar pills. 

In medicine, it's not enough to see that something works. Vitamin C, for example, has a reputation as a cure for the common cold and, indeed, you may have given it a go yourself and found it effective - a few days of popping pills and your cold was gone. 

However, just because it seemed to work isn't evidence that it has an effect. Your cold may have cleared up after three days anyway. In fact, scientists have tested the Vitamin C theory against placebo pills and found that Vitamin C doesn't speed up recovery or reduce the frequency of colds you get. That millions of people take the supplement and feel better is irrelevant; to judge whether a therapy makes a difference, you need to compare it to doing nothing. 

Financial sugar pills

Market indexes and other benchmarks are the financial equivalent of placebos. An index is, by design, completely passive - it's typically a weighted average of share prices for a specific market, say, the 200 largest companies or the biotech sector.  

Anyone can invest in these passive index funds and get the market's average result, less the cost of investing. The costs are generally lower than you will pay at an active manager, too, sometimes just fractions of a per cent each year. For an active fund manager to justify higher fees, they need to add value in stock selection.  

Like our Vitamin C analogy, if you want to know whether your fund manager adds value, it's not enough to see that they had returns of 5% or 10% or are otherwise 'reaching your long-term goals'. To test how effective they are at their job - picking stocks or even tracking indexes - you need to compare their results to a relevant benchmark or index. Ideally, you should select an index that matches the pool of investments in which the manager is investing.

If a fund manager isn't making such a comparison easy for you, they probably have something to hide.

One caveat is that time periods matter a lot in this industry - a manager's results over one, two or even three years often isn't enough to test whether they add value because their skill could be drowned out by the market's short-term volatility, so it's better to look at records of five years or more.

Finding the right index isn't always straightforward, but doing away with benchmarks altogether makes it impossible to tell which fund managers add value to your portfolio. Any manager telling you to focus on your individual goals and ignore the benchmark is probably selling sugar pills. 

Note: This post wouldn't be complete without a pride-laden plug for our own stock recommendations, which have delivered an average annual return of 14.1% and beat the S&P/ASX 200 by 5.2% a year since 2001. You can see our audited results here

Disclaimer
Intelligent Investor provides general financial advice as an authorised representative under the AFSL held by InvestSMART Publishing Pty Limited (Licensee). InvestSMART Funds Management Limited (RE) is the responsible entity of various managed investment schemes and funds and is a related party of the Licensee. The RE may own, buy or sell the shares suggested in this article simultaneous with, or following the release of this article. Any such transaction could affect the price of the share.

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