The Challenges Of Benchmarking Your Financial Adviser

Jason Zweig at The Wall Street Journal reminds us that analyzing an investment adviser’s performance record is still a complicated and convoluted affair. Performance alone shouldn’t be the only measure of an adviser’s value, but it’s not chopped liver either. So, how can we judge an adviser’s record? There are no short cuts, as Zweig points out. Although several consultancies have taken a stab at developing transparent and relevant adviser benchmarks—Brightscope and the Spaulding Group, for instance, according to Zweig—it’s debatable if the challenge has been solved.

To be fair, it’s not obvious that a workable solution is available if we’re looking for one benchmark (or even several benchmarks) that can be used to assess a wide variety of adviser-run portfolios. The problem is that there are many strategies focused on achieving different goals. It’s inevitable that building customized benchmarks comes into play.
Generic benchmarks are still useful, of course, assuming they’re designed properly. What are the attributes of a good benchmark overall? The investment software firm Zephyr Associates cites the CFA Institute’s standards:
• Unambiguous
• Investable
• Measurable
• Appropriate
• Reflective of current investment opinions
• Specified in advance
Where to begin? With a passive index that captures a broad spectrum of the major asset classes. Ideally, such a benchmark represents the investment opportunity set for everyone and so it provides an estimate of what the average investor earns with broad exposure to risky assets. Because this benchmark is passively weighted and owns everything (i.e., the major asset classes), and requires no investing or forecasting skills, it’s a representative portfolio. True, such a benchmark is the optimal strategy only for the average investor with an infinite time horizon, which means that it’s impractical for most of us. But as a robust starting point for evaluating investment strategies, it’s an obvious place to begin.
What’s the logic behind such a benchmark? The answer can be summed up as a mix of common sense and decades of research from financial economists, as I discuss in more detail in my book Dynamic Asset Allocation. Where can you find such a benchmark? You can start with the Global Market Index (GMI), a proprietary gauge that’s updated monthly on these pages, including the latest tally through the end of June 2012. And, yes, GMI meets the CFA standards listed above.
This may come as a shock to some investors, but GMI has performed competitively with a broad sampling of multi-asset class mutual funds through the years. For instance, looking at returns for funds with at least 10 years of history through this past April (according to data from Morningstar Principia software) shows that GMI has given more than 1,000 actively managed asset allocation portfolios a run for their money. A simple regimen of rebalancing GMI’s components tends to earn slightly higher returns; equally weighting the asset classes (and rebalancing back to equal weights every December 31) does even better, or so history shows.

GMI and similarly designed benchmarks are hardly a silver bullet. That said, everyone needs a strong reference point for analyzing portfolio returns. Think of GMI as the investment equivalent of the North Star—a fixed point on the investment horizon that offers a reliable landmark. What can you do with GMI when it comes analyzing your adviser’s record? At your next meeting, you might consider asking him how he plans to add value relative to GMI or a comparable benchmark. Listening closely to the answer may be revealing in itself.