- Benchmarks are more about the managers than the investors
- Indices contain flaws which reduce their usefulness as a benchmark for real-life portfolios
- If you’re going to compare to an index, you'll need to make some adjustments
If you’re a Star Wars fan you’ll know about ‘Jedi mind tricks’. A wave of the hand, a soothing voice and the Jedi Master has you in under their control. In finance, one of the great Jedi mind tricks is the art of ‘benchmarking’, which can determine whether your adviser or fund manager is a hero, or not.
Benchmarking is the practice of comparing someone’s investment performance to an independently calculated index like the S&P/ASX 200. It's something we've thought a great deal about in creating and managing our ASX 200 'Total Return' Index (also referred to as the Accumulation Index). You'll beat the ASX 200 Price Index simply because you've got dividends and franking credits included.
Just be careful not to benchmark too often.
The question of timeframe
Indices encourage ‘short-termism’, especially among fund managers who report their performance monthly. They may talk about long term but a manager that underperforms the ASX 200 month after month may not last to see it.
Individuals face ‘career risk’ (the risk of losing their job) so it can be tough to make sensible decisions over a long-term that may stretch well beyond the day they walk out the door. It’s hard for a fund manager whose performance hovers around the index to lose their job, even though it may cost investors a fortune in long-term returns.
Career risk helps explain why so many large funds effectively end up as ‘index-huggers’. Keeping a portfolio close to the index weightings makes it difficult to go too far wrong, but it reduces the chance of getting it right.
That's a problem for investors, as we'll explain in Part 2 when we tackle our own model portfolios.